A potential threat for alternative investment growth

by Olivier Le Marois and Raphael Douady, 2008

Some of the hedge funds which have been highly impacted by the sub-prime crisis were previously considered, from a naïve point of view, as very unrisky: they exhibited a very high Sharpe ratio, small ex post volatility, no negative months and were de-correlated from all traditional asset classes.

Because of these appealing characteristics, one could have good reasons to be very bullish on these products – to create portable alpha products combining futures and absolute returns funds, to boost the returns of monetary products, or because the national, as well as international regulatory environment were implicitly promoting this type of products.

In fact, if some institutional investors were surprised to burn their fingers during the spring 2007, most of the alternative investment community was expecting this crisis and cautiously stayed away from these funds exhibiting hard-to-believe return characteristics.

These cautious investors feared potential hidden risks behind these appealing return patterns. Returns smoothing enables a fund to hide risk. Because our mission at Riskdata is precisely to promote risk transparency, we decided to test and – if conclusive – to distribute an indicator to warn on potential return smoothing: the Bias Ratio, created by one of our clients, Adil Abdulali, risk manager at Protégé Partners. Our massive tests demonstrated that a substantial fraction of the funds trading very illiquid securities smooth their returns. These practices don’t in themselves represent a systemic risk for hedge funds – like in the LTCM crisis – because it represents only a very small faction in terms of asset under management. However, by introducing a serious breach in risk transparency, it introduces a reputation risk for the alternative investments, which could lead investors to walk away. This is why we think it is the interest of the alternative investment community to ban return smoothing practices.

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