New Edhec paper examines hedge funds' operational risks

Date: Tuesday, February 20, 2007
Author: HedgeWeek

A new research paper from the asset and risk management research centre of French business school Edhec looks at how to quantify the operational risks that can result in hedge fund failures.

In a working paper entitled Quantification of Hedge Fund Default Risk, which led to the publication of a full article in the fall issue of the Journal of Alternative Investments, Jean-René Giraud and Stéphane Daul of the Edhec Risk and Asset Management Research Centre, together with co-author Corentin Christory, have examined numerous cases of hedge fund default in order to find the common factors behind fund failures.

The aim of the paper was to provide an initial framework for quantifying the non-financial extreme risk of hedge funds, with the aim of factoring it into the portfolio construction phase. The paper examines the statistical properties of hedge fund failures and attempts to identify essential risk factors that can tentatively explain why certain funds are more likely to default on their investors and creditors than others.

According to the authors, there are three lessons to be drawn from the study. First, within the parameters of the study, hedge fund operational risk cannot be naïvely diversified without including more than 40 funds, resulting in a possible over-diversification of the financial properties of the funds.

As a result, thorough due diligence is an absolute requirement prior to investing. But investors should keep in mind that an increased number of funds also implies less time to investigate each individual fund and the inclusion of funds with lower standards of operations, hence possibly increasing the final likelihood of default of individual funds.

The cost and complexity of hedge fund operational due diligence can be significantly reduced by performing an 'informed' due diligence process. This informed process will take into consideration the relative importance of the main risk factors to hedge funds in general (such as fraud), and the level of complexity/risk of the specific fund and management company under scrutiny, in order to determine the extent of operational review required.

Not all factors have been analysed, but the authors highlight product complexity (investment style), geography and size as factors that have proven to result in different risk profiles.

An 'informed' diversification of the operational risk in the portfolio construction phase results in significant differences in the risk-adjusted profiles.

Founded in 1906, Edhec Business School is a leading business school with campuses in Lille and Nice, France. It is recognised as a centre of excellence for asset management and alternative investment research and several of its professors are regarded as international experts in the fields of asset management, fixed income securities, alternative investments and risk management.

The Edhec Risk and Asset Management Research Centre's team of 33 researchers implements six industry-sponsored programmes focusing on asset allocation and risk management in the traditional and alternative investment universes. The Edhec Alternative Indexes are measures of performance of the various hedge fund styles.