Why hedge funds?
There has been a misunderstanding of the value proposition of hedge funds. In recent years, hedge fund returns have been poor compared to the market and there is concern about expenses and fees.
Professor Stephen Brown argues that, after all these are accounted for, hedge funds remain a value proposition. This was true before the recent financial crisis and they remain a value proposition afterwards as well. However, since individual hedge funds are risky, the only reasonable way institutional investors can invest is through a diversified hedge fund strategy. Indeed a diversified strategy has about half the risk of the S&P 500 index.
Professor Brown emphasises that this is not a free lunch. There are two major problems associated with these diversified strategies. One has to do with tail risk. Because hedge funds earn rents from the provision of liquidity to the markets, they perform poorly in the rare event of a liquidity crisis, whether a diversified strategy is used or not. The second problem is the operational risk that arises because many hedge funds are reasonably small and obscure.
Professor Brown proposed this argument at a CFA Society of Melbourne (CFAM) lunchtime presentation held on 18 February 2016. Paul Kessell, the CFAM Program Chai, thanked Professor Brown for providing the Society with much to consider. "As investment practitioners, when we assess hedge funds as part of a holistic portfolio strategy, it is always important to consider the range of factors that Professor Stephen Brown touched on."
Professor Brown was recently appointed Executive Editor of the Financial Analysts Journal (FAJ), a leading publication which is published by the CFA Institute. The Department of Banking and Finance is a CFA Program Partner of the CFA Institute, the global association for investment professionals that awards the Chartered Financial Analyst® designation.