How Risk is Measured

When I think about risk I think about the chance I'll lose money. This is how most people think about it and this being the case, why do so many investment texts teach standard deviation as the primary measurement of risk? Standard deviation incorporates both upside and downside variation and most people would agree they have no problem with an above average return or a slightly below average return given the average is positive. What we hate to do is lose money, i.e. negative return. This brings up two points: should the average be used in the calculation of standard deviation or some other benchmark (I might would suggest zero, the S&P or NASDAQ or some other minimum hurdle rate) rather than the average, which is used in standard deviation.

Secondly, does incorporating the full spectrum of deviation (positive and negative) into the calculation make as much sense as only incorporating the variation below your benchmark or hurdle? Since investors are typically more concerned about losing money, it makes sense to separate the negative and positive deviation. This calculation is referred to as semi-deviation (upside and/or downside).

Using a benchmark or minimum hurdle instead of the average in the deviation calculation makes more sense because you are then framing the deviation around the return "tipping point" you actually care about. Calculating the semi-deviations instead of the general standard deviation makes more sense because you then understand which way your deviation is coming from, upside which most people are happy with or downside which is the real deviation people are trying to avoid.

What is Absolute Return?

I remember in college coming across this term and trying to google it (given this was a number of years ago), but nothing pulled up that gave a really good definition. For all of you who are still wondering, absolute returns is simply that, a predetermined rate of return for a given time period that a fund seeks to achieve regardless of the overall market condition. For example, a fund might say they target 15% annual return regardless of whether the year was an overall bear or bull market.

Absolute return strategies are different than investments that benchmark their performance against an index, which varies from year to year, such as the S&P or NASDAQ 100.

When Redemption Limitations Make Sense

Hedge funds have redemption limitation which limits when you can withdraw your holdings in the fund. Some of these take the form of long term commitment requirements while others are a simply minimum notice period, i.e. kind of like the standard "two weeks notice" before quiting a job.

The limitation require the fund managers to focus on investing, not asset management and invest in illiquid assets. The important thing to remember when evaluating a fund is the redemption limitation should be reasonalbe in realation to the expected holding period and the underlying assets.

Hang on for a second and I'll explain. If the fund expects to invest in illiquid investments, such as private equity etc, then you would expect a lockup period similar to a private equity fund which is years, but if the underlying investments are being make in simple index funds, then the period should be daily or ever couple days. The middle case is the fund invests in very liquid assets however their hedges are such that unwinding their hedges to liquidate investors in a short period of time would cause undue losses to remaining investors in the fund. In this case, the fund might have a more stringent redemption limitation to protect the remaining investors in the fund.

In the end, as I said before the redemption limitation should be resonable given the investment assets of the fund and the corresponding hedges.

What is a Hedge Fund?

If you ask 10 people what a hedge fund is, you'll likely get different answers from many of them. In general a hedge fund is a professionally managed, private investment vehicle (not available to the public) and loosely regulated.

However, in Europe the term refers to a fund with the following characteristics:
1. Offshore investment vehicle;
2. Strategy goes beyond buying and selling stocks; and
3. Performance is measured in absolute terms.

In the US, a hedge fund is:
1. A domestic limited partnership;
2. Allowed to investment in many different types of securities with many different types of strategies;
3. Managers are rewarded with an incentive fee; and
4. Does not have to register with the SEC.

Hegde funds are attractive to many investors because of their ability to long, short and hedge their investments (though many "hedge funds" don't actually hedge).