Hedge funds strengthening risk management practices, says MFA study

Date: Friday, September 7, 2012
Author: Emily Perryman, HedgeWeek

Hedge funds are continuing to develop risk management practices that fit the needs of investors and fund managers alike, according to a study from the Managed Funds Association, BNY Mellon, and HedgeMark.

The study, entitled “Risk Roadmap: Hedge Funds and Investors’ Evolving Approach to Risk,” uses qualitative and quantitative data collected from the chief risk officers of global hedge funds, institutional investors, prime brokers, and other industry participants.

The data demonstrates the industry’s increasing focus on risk management and transparency. According to survey results, hedge funds project that five years from now 41 per cent of investor reporting will be published daily or weekly, up from 22 per cent today and just 12 per cent in 2007.

“Today’s hedge funds are operating in a dramatically different environment than five or ten years ago, dedicating more resources to risk management and communicating more frequently with investors,” says Richard Baker (pictured), president and chief executive of the Managed Funds Association. “Improvements to internal governance, independent transparency, quality and frequency of reporting can go a long way to strengthen the partnership between investors and fund managers. As the industry continues to evolve, we will see even more attention given to risk management, helping managers and allocators work together to navigate global markets.”

“Investors are increasingly taking a ‘trust and verify’ approach to a hedge fund’s reported risks and exposures. As a result, hedge fund managers have augmented their reliance on independent, third-party administrators and will continue to do so,” says Orla Nallen, managing director of alternative investment services at BNY Mellon. “More fund managers are turning to third-party administrators not only for operational risk mitigation and transparency support, but also for services that help them expand into new markets and satisfy regional regulatory reporting, such as Ucits exposure and Form PF.”

“Risk has always been central to the investment process, but we are definitely seeing an increased focus on risk from both hedge fund managers and investors,” adds Andrew Lapkin, president of HedgeMark. “For managers, it’s about protecting against unexpected losses and ensuring that the risks being taken are properly rewarded. Investors are particularly focused on many of the non-market risks including fraud, counter-party, liquidity and reputational risk – concerns that have been at the forefront of investors’ move to managed account solutions, only now we are seeing a greater focus on solutions provided by the highest rated providers and fund administrators.”

As new international regulations, including Basel III, the Dodd-Frank Act, and the European Market Infrastructure Regulation bring about significant changes to risk management practices, the study demonstrates that hedge funds today are “increasingly more willing to tell their story in plain language with a keen focus on sharing and explaining their risk approach.” Hedge funds are dedicating more resources to risk management and working to ensure the independence of risk managers, which is a best practice sought by institutional investors. More than 91 per cent of hedge funds surveyed rely on a third party administrator in some risk management capacity.

Other findings included:

• 79 per cent of firms now separate their risk manager and fund manager functions entirely to ensure independent oversight.

• Firms manage liquidity risk most explicitly – 55 per cent treated liquidity risk with the highest importance.

• 60 per cent of the larger hedge fund managers now have a dedicated risk management function.

• 84 per cent of hedge funds use off-the-shelf risk analytics in their portfolio management or trading systems.

The study also identified 14 different types of risk that confront hedge fund managers and investors. These range from the liquidity, volatility and credit risks faced by most funds to such concerns as currency, commodity, and “meta” risk – the latter of which captures all the qualitative risks that cannot be easily measured, such as human and organisational behaviour, or moral hazard.