Hedge Fund and Portfolio Risk Management

Hedge fund industry participants do not always offer the same definition of risk management. Likely, this is due to the dynamic nature of risk and also due to the different level of significance or interest various risk factors will have to different parties.

For example, it is often said that hedge fund managers will tend to have a very focused or granular view of risk factors within their portfolio (based on holdings), while investors will have a bird’s eye view of the fund’s portfolio limited to return streams or top positions.

At Pavilion, we separate risk management into two categories: market risk (which should be rewarded with commensurate performance) and non-market or business / operational risk, which only can impact fund performance negatively and should not be rewarded. This article will focus largely on the former type.

Risk management practices assist managers in both monitoring and reducing their funds’ exposures to unwarranted risks, and reducing exposures to downside risk. Historically, hedge funds invested little in the way of risk systems beyond unsophisticated spreadsheets, and offered low transparency around strategies, risk and market outlook. Following the financial crisis of 2008, increased regulatory and public scrutiny, combined with additional compliance and monitoring, have put significant pressure on hedge funds to better measure and control risk and to be more transparent in the process.

Keys to a successful risk management process focus on the importance of:

    i) establishing a proper risk management framework;
    ii) creating and segregating the risk management function from portfolio trading activities; and
    iii) investing in specialized risk systems (whether internally developed or off-the-shelf through a third-party vendor) which allow the firm to adequately monitor the portfolio.

A recent study1 noted that 84% of hedge funds use off-the-shelf risk analytics that form part of the portfolio management or trading systems.

The due diligence investment process calls for a deep understanding of the manager’s approach to risk management, the components identified as most important and how the manager measures these risk components. This risk management structure must be accompanied by an effective oversight function with reporting lines independent to those managing the portfolio. The same study2 noted that 79% of firms separate their risk manager and fund manager functions to ensure independent oversight.

Managers’ incentives to implement good risk management practices are a function of a number of fund characteristics:

    1) Leverage: Higher borrowing increases the fund’s exposure to changes in asset values. Large losses can lead to margin calls from lenders and redemptions from investors, both of which can require the manager to liquidate the portfolio at “fire sale” prices. Moreover, lenders may implicitly or explicitly require a minimum level of risk management in contractual agreements or legal covenants. Therefore, funds using more leverage would benefit from good risk management.

    2) Fund size: The cost impact of implementing and operating risk management practices decreases with increasing fund sizes.

    3) Alignment of interest: Fund managers with a substantial portion of their liquid net worth invested in their funds are likely more risk averse and incented to implement more extensive risk management practices to better understand and monitor risk exposures.

    4) Reputation: Managers of established hedge funds want to protect valuable reputations. Therefore, they have more to lose, such as their ability to charge higher fees, start new funds or keep existing investors should substantial changes in the value of the fund’s invested assets occur due to unexpected risk exposures.

Portfolio risk management for hedge funds goes well beyond traditional risk management tools such as mean-variance analysis, beta and the various iterations of Value-at-Risk (VaR).

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1, 2 Risk Roadmap: Hedge Funds and Investors’ Evolving Approach to Risk, BNY Mellon, Aout 2012

GENERAL DISCLOSURE: This paper is intended for sophisticated and/or accredited investors and is for illustrative use only. While the assumptions, data and models used to develop the information contained herein are from sources deemed to be reliable, there can be no certainty or guarantee regarding the likelihood of the outcomes as presented. This document is not and should not be construed as legal, taxation or investment advice. Any investment advice would be delivered pursuant to a written agreement and legal and taxation advice should be obtained from appropriate and qualified professionals. No part of this publication may be reproduced in any manner without our prior written permission. © 2016 Pavilion Advisory Group Inc.