LONDON Investors may often be in the dark about the risks hedge fund managers are taking in their funds to build impressive-looking track records, according to a leading academic.
Many fund managers are opting for so-called "nickel" strategies, which yield small gains most of the time and build a track record that can help retain client money, but bear the risk of huge losses once in a while.
"Investors should be aware of the risk (of) potential large losses ... It is quite possible that many individual investors are not," Hongjun Yan, assistant professor of finance at Yale University, told Reuters in an interview.
"If I (as a fund manager) have a nickel strategy, I know I'm likely to get five years good returns and even if it crashes I can start up (again)," Yan said.
Some 40 percent of hedge funds invest in nickel strategies, Yan said, which yield frequent small gains and a dramatic loss every once in a while -- just like picking up nickels in front of a steamroller.
The number of the strategies may be higher still, because funds with big losses may stop reporting, Yan said.
Nickel trades include shorting S&P 500 .SPX index put options, carry trades and convertible arbitrage.
Merger arbitrage, where funds buy the shares of a bid target and short the buyer, is another example, Yan said. This can yield gains of 2 or 3 percent, which can be levered up.
But when a deal falls through, the loss can often be around 30 percent, and much more if a manager is using leverage.
Yan also said hedge fund managers, for whom keeping hold of investors' money has become a bigger issue than ever as the credit crisis has taken hold, often ignore strategies that could theoretically be more profitable in the long term.
But fund managers are wary of such so-called "black swan" strategies because investors may lose patience in the meantime and pull out their money, Yan said.
"Even if there is such a strategy, investors will be scared about taking it," he said.
The pressure is particularly on younger managers, who have no stellar track record to fall back on and for whom the temptation to follow nickel strategies is real, particularly after many clients were stung by heavy losses in the sector in 2008.
"Reputational concerns apply more to younger managers. Warren Buffett is not too worried about people having doubts. Even if he delivers a few years of negative returns people will still invest," Yan said.
(Editing by David Holmes)