Within the equity risk sub-module of the third Quantitative Impact Study (QIS3) undertaken by the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS), a preamble to the Solvency II supervisory standard, all alternative investments are subject to a capital charge of 45%, nearly 50% higher than the 32% applied to regular equity exposures.
In this article, we will briefly go over the calculations required for equity risk, and then include a reminder of why hedge funds on average are certainly not the riskiest bet an investor can make.
Solvency II – The Equity Risk Sub-Module of Market Risks
The main features of the equity risk sub-module are as follows1 :
- The equity risk sub-module is intended to capture systematic risk, whereas idiosyncratic equity risk is addressed in the concentration risk sub-module.
- The Mkteq,i capital charge is determined as the immediate effect on the net value of assets and liabilities expected in the event of the stress scenario equity shocki, taking account of all the participant's individual direct and indirect exposures to equity prices. It should therefore be assumed that the beta of all positions is 1.
- The equity exposure of mutual funds should be allocated on a look-through basis. If this is not feasible, the exposure has to be attributed on a best effort basis.
- For the determination of this capital charge, all equities and equity type exposures have to be taken into account, including private equity. This comprises emerging markets, non-listed equities and alternative investments. “Alternative investments” include all types of risk exposures like hedge funds, derivatives, managed futures, investments in SPVs, CDOs (the equity tranche) etc, which cannot be allocated to spread risk or classical equity type risk.
- For the calculation of the risk capital charge, hedging and risk transfer mechanisms should be taken into account. However, the rule is quite restrictive, as management actions and dynamic hedging strategies are not integrated, and only instruments with a one-year maturity at least are taken into account.
- The stress scenario for developed markets is that of a 32% price fall, while the stress scenario for all other exposures accounted for in the equity sub-module is that of a 45% price fall. The two resulting capital charges are aggregated with a correlation coefficient of 0.75.
In practical terms, this means that all hedge funds with positions that cannot be looked-through or which are managed dynamically rather than protected with listed 1-year put options will be subject to a 45% capital charge.
EDHEC’s work clearly shows that this capital charge is totally inconsistent with the real risk profile of hedge funds. Indeed, hedge funds as an asset class are far less risky than stock indices: funds of hedge funds have an empirical downside risk with a 5% confidence interval of 3.69%, three times less than the S&P500’s downside risk of 10.73%.
Source: V. Le Sourd (2007)
The above table suggests that the stress scenario for a well-diversified position in hedge funds should be four times less than that for equities, or 1.71% rather than 7.12%. Since the risk scenario for equities is 32% with a 1% confidence interval, the stress test for hedge funds should be four times less than for equities, ie 8% instead of 45%.
Hedge Funds – Irrational Fears
One can easily conclude from the large gap between CEIOPS’ perception of hedge fund risk and the “let the data talk” approach followed by EDHEC that fears rather than data have been the reason for this strong penalisation of hedge fund investments.
This is not necessarily all that surprising when one considers the poor reputation of hedge funds. Operational problems, political issues surrounding their interventions, failures and lack of transparency have been widely publicised, often at the expense of objective data.
Hedge funds are often accused of leading to systemic risk; of being a threat to the businesses they target; and of being extremely risky for private investors because of the risk of fraud and a “bet the house” attitude.
EDHEC’s research has proved that most of these preconceptions are statistically unfounded.
- Hedge funds and systemic risk. The fear of systemic risk may have its roots in 1998’s LTCM debacle, when a single default impacted the financial system and prompted intervention from the Federal Reserve. The situation has largely improved since, with in particular leverage from hedge funds being more reasonable today than ten years ago2 – leverage is also more scrutinised by hedge fund investors and counterparties. As a result, losses from Amaranth, which were almost twice as big as those from LTCM, were easily absorbed by the private sector without intervention from the authorities. Another source of concern is the idea that these very active investors behave like sheep, and may amplify any strong market stress. This idea, often referred to as crowded trades is largely invalidated – hedge funds, even within a defined sub-class, have very varied strategies and do not behave as a single investor.
- Hedge funds: a threat to firms that are targeted? The fear that hedge funds may put target firms at risk appears to be used often as an argument by management to defend their strategies against those proposed by new investors. In practice, hedge funds nowadays take minor holdings in firms and could not dismantle a business by themselves. And from a statistical point of view, their proposals clearly help firms outperform the market (positive alpha).
- Hedge funds are less risky than equities! As far as risk is concerned, EDHEC’s research has shown that hedge funds provide considerable diversification benefits for portfolios. As they use a far broader range of instruments and strategies than indexed funds, they give investors access to more risk factors and diminished risk than otherwise possible. Even without accounting for diversification benefits within portfolios, hedge funds on their own are shown to be less risky than regular equity investments (see table above).
- Hedge funds are subject to default risk. An individual hedge fund may go bankrupt because of fraud or other operational risk. However, not only is default risk very low (0.3%), it also appears to be very stable, so despite banner headlines, default risk is only a small part of the overall risk of investing in a diversified portfolio of hedge funds.
The natural conclusion is that the overall risk of investing in hedge funds must be considered to be much lower than that of investing in equities. EDHEC thus totally disagrees with the harsh penalisation of hedge funds as proposed by CEIOPS. We recommend correcting this by significantly lowering the stress scenario for hedge funds and at the same time significantly increasing the assumed diversification benefits from such investments. Due to the presence of default risk, EDHEC also recommends raising the penalty for concentration risk in hedge fund investments: an exposure to only one or two hedge funds makes it possible to lose the full amount invested, so companies that make large bets in single hedge funds should be penalised.
1 Note that we do not recall the calculations required to estimate the reduction for profit sharing, as this is neither specifically related to equity risk nor to the way hedge funds are treated.
2 LTCM had a leverage of 30 on Russian debt. According to the CISDM and TASS hedge fund databases, between January 2000 and March 2003, the average leverage was 3.17 for Convertible Arbitrage, 1.81 for Equity Hedge, 1.61 for Event Driven, 2.10 for Distressed Securities, 2 for Merger Arbitrage, and 1.94 for Equity Market Neutral. Other empirical estimates give the same order of magnitude.