In some circles, stop-loss is touted as an effective risk management tool for individual investors. But while it might work for some people, it’s not always clear whether hedge funds use stop losses. Because funds are generally more sophisticated and larger-scale than individual investors, many are left to wonder whether stop loss is utilized as a risk management tool by them.
Some hedge funds use stop-loss. However, the proportion of hedge funds that use stop-loss is lower than funds that use other risk management methods. That’s because most hedge fund managers believe that stop-losses increase transaction costs and take funds out of desirable positions.
Read on for details on the percentage of hedge funds that use stop-loss, and also learn why some fund managers rely on other risk management tools – completely avoiding stop-losses as a risk management instrument.
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Do All Hedge Funds Use Stop-Loss?
Not all hedge funds use stop-loss; some do while others don’t. Whether a hedge fund uses this risk management technique depends on its reliance on human intuition.
Quant funds, whose strategies are purely based on statistical and mathematical modeling, are more likely to use stop-loss than fundamental hedge funds, which base their investment strategies on a combination of quantitative analysis and human intuition.
Broadly speaking, there are two ways hedge funds use stop-losses. Some funds use strict/hard stop-losses, while others use tiered monitoring. With a hard stop-loss, a position is sold when the triggering price is hit.
On the other hand, tiered monitoring involves tracking positions and re-evaluating them whenever a stop-loss is hit. This means that a stop-loss getting breached on a particular position doesn’t necessarily mean selling it.
Generally, hedge funds that use strict stop-losses are fewer than those that either use tiered monitoring or don’t use stop-loss at all. So while stop-loss is still used in hedge funds, it’s not that common.
This sentiment was echoed in a 2014 Hedge Fund Journal report, which found that most hedge funds don’t use stop-loss. Out of the examined sample, only less than 20% of the hedge funds indicated that they utilized strict stop-losses to mitigate risk. The remainder preferred to use tiered monitoring or didn’t use any stop-loss methodology.
Hedge Funds And Stop-Loss
Even though stop-losses come with several drawbacks, they can be beneficial in certain situations. That’s why opinions on their use in hedge funds remain divided.
To clarify, let’s review both sides of the coin.
Why Do Some Hedge Funds Use Stop-Loss?
Given that most hedge fund managers prefer other techniques over stop-loss, it’s easy to think that this risk management tool is virtually useless. However, that’s not necessarily the case.
Stop-loss orders can help minimize losses in certain positions and possibly help lock in profits. Notice that there are two parts to this statement: minimizing losses and locking in profits.
To illustrate how a stop-loss order can help cut losses, let’s consider a Commodity Trading Advisor (CTA) fund that trades concentrated positions in a few liquid assets, generating profits by capitalizing on market trends.
If such a fund loses money on a given position due to a misjudgment of market trends, the sensible course of action would be to get out of the position and wait for the right opportunity to jump back in.
In such a case, a stop-loss can help cut losses. That’s because the position was held based on misleading information about a market trend, meaning staying in it would lead to further losses.
A stop-loss can also help the CTA in the above example lock in profits on a given position. That’s particularly true if the CTA uses trailing stop-loss.
Trailing stop-losses move by a predetermined margin as long as the underlying asset’s price change is favorable. For instance, if the entry price for a position is $200 and a trailing stop-loss of 10% is set, the initial stop-loss is set at $180.
Assuming a price increase is desirable for this particular position, the trailing stop-loss would move up to $225 if the underlying asset’s price rises to $250. Since it can never move back down, the fund would sell the position for a $25 profit even if the price drops enough to trigger the new $225 stop-loss.
That, in a nutshell, is how a trailing stop-loss can help some hedge funds lock in profits.
In addition to helping hedge funds cut downsides and lock in profits, stop-losses can also free up capital. The rationale is that hedge funds are typically diversified portfolios, and getting a stop-loss order triggered on a losing position frees up capital to be invested in other positions with potentially better risk-reward ratios.
Last but not least, stop-losses can help prevent extreme losses in stress scenarios like an unprecedented equity crash. However, whether this counts as a benefit varies with individual funds because stress situations can sometimes present good investment opportunities for diversified quant funds.
Why Do Some Funds Avoid Stop-Loss?
Hedge funds that ditch stop-loss for other risk management techniques do so for two reasons:
- Stop-losses may take funds out of desirable positions.
- Stop-losses may increase transaction costs.
Let’s delve deeper into each of these reasons below:
Stop-Losses May Take Funds Out of Desirable Positions
Some hedge funds use a mean reversion strategy to maintain a negative autocorrelation between returns from various positions in a portfolio.
For instance, a fund manager might bet on companies with bad reputations to bounce back into the mainstream or adopt a value trading strategy where they buy positions in assets they think the market is currently underestimating.
In such situations, stop-losses can systematically take the fund out of desirable positions. That’s because the prices of the assets in both situations might keep dropping before eventually rallying, which might trigger the stop-loss.
Stop-losses may also get a hedge fund out of desirable positions due to market corrections, a common occurrence in many healthy bull markets. If sentiment-driven drops trigger a fund’s stop-loss, it loses its chance to capitalize on recovery, which often follows a correction. This doesn’t just get the fund out of a desirable position; it also locks in losses.
Stop-Losses May Increase Transaction Costs
Having a stop-loss limit that gets hit frequently can be costly. That’s because every time the stop-loss is hit, a sell order has to be issued, which increases the transaction costs. That’s particularly true in volatile markets, where assets can fluctuate wildly and trigger stop-loss orders unnecessarily.
Stop-losses can also be costly for hedge funds that trade in assets with limited liquidity. When the limit is hit for such assets in volatile markets, there can be unfavorable differences between the stop-loss price and the actual execution price for its sell order due to what’s known as slippage.
Should You Invest in a Hedge Fund That Uses Stop-Loss?
Schools of thought differ on the practicality and value of this risk management technique, but it all comes down to execution. Some funds effectively manage risk using stop-losses, while others do just fine without any form of stop-loss.
If you end up investing in a hedge fund that uses stop-loss, be sure to find out whether its stop-loss limits conform to your risk profile. You’ll also want to find out whether the fund manager is actively involved in tracking the various positions and evaluating them against the stop-loss because this can help counteract some of the common challenges associated with the use of stop-loss in hedge funds.
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Ultimately, whether a hedge fund uses stop-loss comes down to its fundamentals. Things like its reliance on human intuition (vs. statistical and mathematical modeling), the liquidity of assets under management, and trading strategy are critical determinants of whether a hedge fund prefers stop-loss over other risk management methods.
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