Hedge funds are often mistaken to have risks similar to other investments like mutual funds and measured on similar quantitative metrics. However, they have their peculiar qualitative risks that make them specific to analyze and evaluate. Here, we will evaluate some of the most common risks for hedge fund investors and ponder over some broad qualitative and quantitative issues that need to be evaluated.
Risks due to leverage
Hedge fund managers are paid a percentage of the returns, and if the fund loses, they lose their share too. This way, the fund manager has to be highly tolerant to risk, while the investors too stand the chance of losing their all money that could be in millions. So, one should invest only that much money which one is comfortable to lose.
Hedge funds invest in derivates, which again make it highly risky due to leverage. Options must be delivered within speculated time frame. If something completely unexpected happens during this time, the fund may lose all its investments.
The lack of oversight by SEC creates additional risks for the funds. The investors to the fund are its part owners, and they may lose their money if the fund goes bankrupt, even though some investments might be doing well.
Other risks associated with these funds include:
Pricing risk: The assets may be quite complicated, thus it could be really hard for the managers to price the securities appropriately.
Short squeeze risk: This occurs when one has to purchase the securities one sold short before one needs to. This happens when the investor from whom you borrowed the security demands for its buy back before the anticipated time.
Counterparty risk: If some dealer or broker cuts off the fund, it could have serious repercussions for the participants.
Liquidity: In extreme market conditions involving illiquid securities, liquidity issues can make the whole fund collapse.
Leverage: This is one of the prime reasons for the hedge funds to incur losses. As the leverage increases, negative effect on the fund also increases in the same proportion. So, the fund managers may have to sell the assets at high discounts to cover the margin calls.
Financial squeeze: The situation occurs when the lending platform is unable to borrow or borrow the hedge coins at the acceptable rates. Other factors that cause financial squeeze include overextended credit lines debt and defaults issues.
Qualitative risks: Evaluation of the management is important. A talented manager may have strong abilities and perform well, but his individual contribution will be blunted if the fund is not managed properly.
Scale matters: Scale is also in important consideration to take into account. While it could be evaluated though the analysis of quantitative metrics, it requires qualitative analysis to determine if the strategy adopted by the fund will be affected by its too large of amount and diversification, and how the returns will be affected.
A hedge fund often outsources its many non-investment functions. So it becomes crucial for them to be at a level for its effective functioning. Trading systems need to implement the fund manager’s idea for maximum returns and minimizing the trading costs.
Right strategy is important for success: One needs to look beyond the numbers and statistics while making investment in hedge funds, lending platform or ICOs and cryptocurrencies. The investors may be lured into the fund if the risks mentioned above are not properly analyzed in the context of overall strategy. While some risks are unconditional, such as the integrity of the management, others can be specific to the strategy adopted by the fund managers.
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