How to Manage Hedge Fund Risk

Hedge fund risk management is crucial to the fund's long-term success.

Managing risk at a hedge fund is an extremely difficult task. It involves keeping track of countless variables, constantly watching out for new threats and measuring results on a real-time basis. At the same time, most hedge fund employees who generate revenue will find that risk management prevents them from taking actions they would otherwise take, so managing hedge fund risk also requires diplomatic finesse. Fortunately, hedge funds that manage risk are often able to take advantage of opportunities when other funds are scrambling for capital, making the entire practice worthwhile.

Things You'll Need

• Risk-management parameters
• Access to portfolio data
• Access to quotes
• Information on counterparty agreements

Instructions

Managing Short-Term Risk

1. Determine the fund's current assets and liabilities. While this is often done from an accounting perspective, a risk manager will have a different view. A risk manager will determine the correlations between assets and the expected variation in the portfolio's total value. While this is easy to estimate for exchange-traded assets, it can be difficult to model the correlations between over-the-counter assets. One best practice is to measure the fluctuations of similar exchange-traded assets. For example, a private loan's expected volatility could be estimated by looking at the volatility of a group of bonds issued by companies in the same industry and at the same credit level.

2. Determine the variables that can cause the fund to fluctuate in value. There are many variables that can cause a change in portfolio value, but a small number will have a large effect. If a fund is primarily invested in a single country and asset class, the performance of that country and asset class will dominate the portfolio's performance. In the short term, if a fund invests in Russian equities and the Russian equity market crashes, the fund is almost certain to have losses.

3. Determine the effect of new trades on the fund's risk position. Rather than run the entire risk study from scratch, it's better for a fund to determine how different trades will affect the entire portfolio's risk. Since most trades involve expanding an existing position instead of creating a new one, this can be determined in advance.

4. Find offsetting risks. These are assets that correlate inversely, such as a producer and consumer of the same commodity. These pairs of assets are useful to identify for portfolio managers, since they represent a part of the portfolio that has lower risk than the rest. This gives managers a chance to take larger positions in the same trade, or to find other similar trades, since they are less likely to cause harm to the entire portfolio.

5. Identify "problem" assets. There are some trades that add extra risk but do not add much return. A fund that invests too much in taking lots of small risks will be vulnerable to a blowup. Many funds have sold insurance against improbable events, only to find that these events happened when the firm most needed extra cash on hand.

Managing Long-Term Risk

1. Stress-test the portfolio for adverse market effects. Determine what would happen if correlations between assets suddenly rose. This is a common symptom of market panics: when many asset managers have the same assets, they may sell them all at once, leading to new correlations. For example, if most asset managers buy mortgage-backed bonds and emerging-market stocks, these assets will correlate even though they are fundamentally unrelated.

2. Calculate a worst-case cash position. This is useful for funds that use leverage. In a market panic, they may find that creditors are unwilling to extend credit, and counterparties are reluctant to provide collateral. This can lead to a fund running out of cash.

3. Find appropriate hedges. Once a fund's worst-case scenario has been calculated, it's possible to find hedges that will only pay off in that scenario. In the case above, a fund worried about a simultaneous crash in mortgages and emerging markets might place a bet on a sudden crash in both at once. This bet would only pay off in a worst-case scenario, and would thus cheaply reduce risk.

4. Create a backup plan. Some funds reorganize a new fund after major losses, so they can continue to charge fees. A backup plan allowing this to happen will help a fund react quickly to market moves.

5. Give traders ways to reduce risk. A risk manager can point to areas where the fund has little or no exposure, since investing in these areas reduces overall risk. Another option is for the risk manager to find out which industries the fund has excess exposure to, and suggest that traders find vulnerable companies in the industries to bet against.

Tips & Warnings

• Use coherent risk-management frameworks.

• Remember that panics are unique.

• Work closely with portfolio managers.

• Make sure outside investors know about the fund's risk policies.

• Avoid investing too much in hedging.

• Always have extra liquidity on hand.

• Remember that investor withdrawals can happen at inopportune times.

References

• Barry Schachter: Theory and Practice of Risk Management in Hedge Funds.
• Richard Wilson: Hedge Funds Risk Management