Human nature to fear risk

People behave irrationally about hedge funds because they don’t quite understand how they work.

There is a long-standing belief among asset allocators that traditional investments – i.e. long equities, long bonds (or their mutual fund equivalents) are “conservative”. Hedge fund investments, meanwhile, are considered “high risk”, appropriate only for very wealthy and sophisticated investors. Well, let’s look at some statistics. During recent years, equity investors would have had to endure a decline in their assets from the March 2000 peak to the September 2002 low of approximately 45 per cent if their portfolio were similar to the S&P500. For investors who had technology-laden portfolios more closely represented by the Nasdaq, the loss during the same interim would have been close to 75 per cent. This is a conservative investment. In contrast, the worst experience of the average diversified hedge fund investor, as represented by the HFRI fund of funds index, would have been an approximate 13 per cent decline from May 1998 to October 1998. Incredibly illogical How is it that an investment that loses less than 15 per cent is considered much riskier than one than can lose 50 per cent or even 75 per cent? The explanation lies in the fact that humans are incredibly illogical when it comes to making risk judgements. Irrational perceptions regarding risk are hardly the exclusive domain of hedge fund investing. To cite a few examples: why do so many Europeans avoid eating meat because of a fear of mad cow disease – one is considerably more likely to be struck by lightening than this ailment – while blithely smoking themselves into oblivion, an action with known devastating health consequences? Why will some people drive long distances to avoid the risk of flying when the chances of them being killed in an automobile per mile travelled are far higher? Why will the fear of shark attacks – a rarity – deter far more people from swimming in the ocean than the fear of drowning, which is a far more likely event? These examples illustrate certain behavioural biases in peoples’ attitudes toward risk. First, there is an inverse relationship between familiarity (or knowledge) and fear. For example, the connection between smoking and cancer or heart disease has the ring of familiarity, whereas the mechanics of contracting mad cow disease are poorly understood. Second, ironically, the very rarity of an event enhances its potential for inducing anxiety because rarer events are more likely to receive prominent media coverage. The shark attack may make the evening news and might possibly even be the lead story. When was the last time you saw a news story on a drowning death? A plane crash is a news event; the car crash isn’t. Publicity distorts peoples’ assessment of risk by making the unusual seem common or by simply heightening peoples’ sensitivity to rare risks that would otherwise have been ignored. Either way, heightened media focus contributes to such anomalies as chain smokers panicking about mad cow disease. Third, people appear to perceive greater risk in a rare event over which they have no control than in the more commonplace occurrence they can influence. Hence, shark attacks engender more anxiety than drowning, fatal plane crashes more fear than fatal car crashes. Biased perceptions These three inherent human biases in the perception of risk explain why people are fearful about investing in hedge funds, but not mutual funds, even though indexes in the former show maximum equity drawdowns less than one-third the size of the latter. First, people are unfamiliar with hedge funds and don’t understand the broad range of strategies they employ, but are quite familiar with mutual funds and fully understand the concept of being long a portfolio of diversified stocks. Second, the hedge fund that loses 50 per cent or more of its investors’ capital is a colourful news story. The mutual fund that does the same is one of hundreds or perhaps even thousands that have witnessed such declines in recent years. Third, people have far more control over their mutual fund or direct equity investments, which can be redeemed daily, than over hedge fund investments, which are subject to lock-up and notice of redemption periods. The key point investors need to realise is that these three inherent biases lead to irrational investment decisions. It is impossible in this brief article to provide an adequate overview of hedge funds, let alone even the most cursory explanation of the many types of strategies they employ. Suffice it say, if you don’t already know this information, you are not in a position to even think about selecting individual hedge funds as potential investments. This does not imply that you shouldn’t consider hedge fund investments for your clients – quite the contrary, as will soon be explained – it merely means that the selection should be delegated to an experienced professional. There is one basic concept, though, that all investors should understand about hedge funds, and that is the key rationale of why they are not only a legitimate investment, but even a compelling one. Standard alternative Begin by considering the standard alternative of a purely traditional portfolio. An investor in traditional funds has a choice of equity funds and bond funds. There is very limited potential for diversification. Within each of these categories – equities and bonds – the funds will be very highly correlated. In other words, selecting multiple equity and multiple bond funds will add precious little diversification over a portfolio consisting of a single diversified fund of each kind. Moreover, stocks and bonds are also significantly correlated to each other. This is why, counter to popular beliefs, purely traditional portfolios are high risk – it is an inevitable consequence of their inherent poor diversification. In contrast, one tremendous advantage of hedge funds vis-ŕ-vis traditional investments is that they encompass an extremely diverse range of strategies, many of which have low correlations to the stock market as well as to each other. This much richer palate of investment colours makes it possible to construct a diversified hedge fund portfolio that offers considerably better return/risk than can possibly be achieved by a traditional portfolio. Note the emphasis on return/risk as opposed to return alone. Also note that achieving this strong diversification benefit requires investing in multiple hedge funds (at least 10-20) or alternatively, and far more easily, a fund of funds. What about those periodic hedge fund horror stories? Isn’t it true that some hedge funds blow up because of fraud, lax risk controls, or grossly flawed strategies? Yes to all of the above. It is also true that there are sharks in the ocean that sometimes attack people, but the reality is that there are far more drownings. One needs to caution against assuming the frequency of news stories is related to the frequency of the event. Often, as in the case of shark attacks versus drownings, the exact opposite is true. Similarly, the hedge fund fraud or catastrophic investment strategy is news precisely because it is a rare event. Severe Consequences Of course, just because something is a rare event doesn’t mean you can ignore it. Severe consequences can outweigh low probabilities. So it is no more advisable to rely on probability to be spared the one hedge fund fraud in a thousand than it would be to forgo fire insurance on your home because the odds of conflagration are very low. Insuring against such a hedge fund investment catastrophe implies investing in a fund of funds. Unless, of course, you are dealing with extremely wealthy clients who can afford to invest in 10 or 20 funds, requiring a typical minimum investment of E1m apiece, and have the expertise to select individual funds. A fund of funds greatly mitigates the chances of experiencing a large loss in a hedge fund investment in two ways:

• The investment analysis and due diligence typically performed by the managers of these funds make it less likely that they will pick a fraudulent or seriously flawed fund.
• Even if a disastrous fund is selected, diversification will greatly limit the damage. Typically, a fund of funds holds between 10 and 50 individual investments. So even in the extreme case where a fund of 20 funds selects a vehicle that loses 100 per cent of investors’ money, assuming equal allocations, the impact at the fund of funds level would be a 5 per cent loss. This is less than the loss in the typical mutual fund during a bad month for equities. In conclusion, an analytical rather than emotional evaluation of portfolio alternatives would indicate that hedge funds – via fund of funds, which provide both professional management and diversification – are desirable investments for all investors who can meet the minimum subscription requirements. It could be argued that such an investment is not merely acceptable for investors with low-risk profiles, but especially appropriate to such investors, popular beliefs notwithstanding. The true high-risk investment is the typical traditional portfolio, which is inherently poorly diversified. Jack Schwager is manager of Fortune Asset Management’s Market Wizards Fund

‘The hedge fund that loses 50 per cent or more of its investors’ capital is a colourful news story’
Jack Schwager, Fortune