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Hedge Fund risk management more important than ever

Date: Thursday, March 20, 2008
Author: Threadneedle.com

As the credit crunch continues to take its toll on financial markets, with several hedge fund managers the latest victims of an illiquid market, Malcolm Kemp, Head of Quantitative Research at Threadneedle looks at why risk management is more crucial than ever in the management of these higher risk strategies.

Hedge funds have a number of characteristics which set them apart as candidates for rigorous risk management practices. These include:

  • A focus on alpha delivery – investors want alpha delivery to make sense in the context of their overall risk budget. Hedge fund managers therefore need to have a keen appreciation of these risks if they are to do a good job for their investors
  • Rapid response to market events – “high performance cars typically need high performance brakes”
  • The employment of leverage and shorting – with larger and more dynamic positions, hedge funds are potentially exposed to greater risks
  • The use of more sophisticated instrument types with a focus on less well researched market areas – innovation requires greater risk controls. As a result of the increased volatility in risk appetite recently, hedge funds need to take a closer look at their position in a “crowded trade”.

What are the risks when it comes to shorting?

  • Not all investment managers are temperamentally suited to shorting
  • The behaviour of shorts is not always qualitatively akin to the inverse of the behaviour of longs
  • At an individual stock level, a particular risk on the short side is that a stock which you might think of as having poor prospects (and hence are short of) gets bid for and its price jumps up.
  • Risk management involves an appreciation of the merits of diversifying the short book and an understanding of the market/sector dynamics that might lead to an unexpected bid up in important short positions

How can a portfolio manager address risk management?

Malcolm Kemp comments: “It goes without saying that a talented manager needs to have a detailed appreciation of the market dynamics relevant to the market segment in question, as well as an understanding of the risks and rewards of the different strategies that might be employed.

“However, the house itself needs to cultivate a culture whereby developed risk disciplines are firmly established in addition to robust risk systems that enable fund managers to identify what might influence future portfolio behaviour.”

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