Risk Management Is Now Vital to Hedge Strategy

Financial News, October 6, 2002 | Go to article overview

Risk Management Is Now Vital to Hedge Strategy


Byline: Mark Pelham

The fall of Long-Term Capital Management (LTCM) in 1998 ensured that the world at large had some understanding of the term 'hedge fund'. The downside of the market's new high profile was the common perception that hedge funds are excessively risky investments.Just as the end of the equity bull market in 2000 had provided huge opportunities for those providing alternative investments, many hedge funds have realised that they have to market themselves in a different way.

Promises of high returns are no longer enough; it is equally vital for the funds to be able to show that they manage risk effectively.

According to Jonathan Hughes-Morgan, managing director at hedge fund manager Thames River Capital: "Investors are becoming more aware of risk-adjusted returns. That is, what is the risk you are taking to make this return - particularly, of course, when the market is falling? People will always pay more attention to downside risk as opposed to upside risk."

As a result, many analysts and investors alike look beyond a fund's Sharpe ratio (the long-used measure of volatility in a fund's returns) and examine its Sortino ratios, which measure downside volatility.

However, while useful indicators of a fund's strategy and approach, they are only clues to what has happened in the past.

Similarly, the risk measurement systems offered by IT vendors are not enough in themselves. Ultimately, risk management can only be effective if it is a core discipline within the hedge fund management company itself.

Nonetheless, in the risk management arena, as in most other areas of a hedge fund's business, prime brokers can be an invaluable ally for any hedge fund manager. For most prime brokers, risk management is an integral and vital part of their product offering.

First and foremost, prime brokers need to have a robust monitoring system in place that allows them to protect their own exposure.

Prime brokers also need to develop a sound understanding of the needs of particular hedge fund clients to ensure that their leverage policy is consistent, particularly in times of market disruption and volatility.

Most of the leading prime brokers carry out extensive scenario testing to simulate the loss to a given portfolio in various market conditions.

Some firms, such as Bear Stearns, employ a proprietary system, which enables them to identify hedge funds that may require specific attention, particularly in terms of liquidity and pricing.

The process of setting levels of leverage is generally initiated at the start of any prime brokerage relationship.

Following a thorough analysis of the diversification and strategy of the particular fund, and a portfolio simulation using the risk system, a level of leverage is decided on.

The range of risk factors considered by prime brokers when taking on a new hedge fund client are determined by market conditions and events, and are subject to continuous review.

For example, following interest rate tightening in 1994, many convertible arbitrage hedge fund players seized the chance to short government debt as a hedge. This meant prime brokers had to build a stress test, taking this strategy into account.

More recently, credit crises caused by accounting scandals such as Enron and WorldCom have led to many prime brokers reviewing the scenario tests they employ for corporate bonds and other credit instruments.

But it still ultimately comes down to the funds themselves.

Jacob Schmidt, director of hedge fund research at Allenbridge Hedgeinfo, an independent hedge fund rating and research service, observes: "Risk management has become a big issue for investors and, therefore, for managers. …

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