Hedge funds didn’t perform well in the years following the 2008 crisis. But the first quarter of 2012 was a different story. Long-short strategies returned 6.1%; multi-strategy funds 4.93%; and relative value funds 4.29%. For a client making investment choices, those returns may be pretty attractive.
It’s easy for investors to be attracted to high returning alternatives. What they may not understand is the amount or the nature of the risks they may experience to get those higher returns.
Risk tolerance is difficult to assess on the front end, based on answers gathered on a questionnaire. Behavioral economists Daniel Kahneman (a Nobel Prize winner and largely thought to be the most influential psychologist on the planet) and Richard Thayer have tried. And they’re not sure it can be done.
This is because risk is a situational experience and it’s almost impossible to know how a client will really feel about a portfolio decline in the double digits until it actually happens. The answer might be to develop some type of virtual reality exercise based on the different types of risk alternatives may present.
With around 7000 hedge funds, 1800 private equity funds, and 500 real estate and infrastructure structure funds in the alternatives universe, it can be challenging to manage investor expectations. Here are some talking points you can use to educate clients to make more informed decisions.
You may want to start by explaining the purpose of hedge funds. Put simply, they’re designed to offset downward movements in other securities or markets, not to deliver stellar returns.
A wise approach to alternatives is to invest in multiple strategies. This can be done through hedge funds of funds or by combining different types of alternative investment vehicles.
Beyond these two starting points are the different types of risk.
Basis risk involves hedging two components that are not evenly matched. For example, hedging a single stock with a market or sector index.
Liquidity issues can be in the form of trading spreads within the fund or overinvestment in illiquid vehicles. Even very sophisticated investors got caught in this situation during the 2008 crisis.
Over leveraging was an issue with Long Term Capital Management debacle in 1998—to the extent that it almost derailed the entire financial system.
Strategy risk is unique to the strategy the fund employs. For example, managed futures will carry different risks than long-short or distressed debt strategies.
Value at risk is the probability of maximum loss over a specified time frame.
Other risks include the use of derivatives and correlation. Stress testing, budgeting for risk, and proper due diligence can reveal these types of risks.
Investors added over $50 billion to the alternative space just in the first quarter of 2012, bringing total assets invested to over $1.76 trillion.
You may be able to open great conversations with your clients by talking about popular investment trends like investing in alternatives. If you can find everyday terms to connect with the risks they may experience, you can help them make a more informed investment decision.
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