Hedge Fund Risk Management: Lessons from 2008

Date: Tuesday, October 23, 2012
Author: ProHedge UK

As part of the PROHEDGE “Get ready for GAIM” series, we covered some of the challenges in hedge fund risk management in anticipation of a talk from Dr Christian Szylar, Global Head of Risk and Performance Measurement at Marshall Wace.

 In one of the more animated talks at GAIM Ops 2012, Syzlar, speaking from his home-territory of France, outlined his thoughts on some of the trends in hedge fund risk management since 2008. “All we knew and learnt about risk management is dead.”

Some may brand this as a harsh assessment, but Syzlar is a realist and according to the facts and statistics “In 2008, we failed as risk managers”. Nevertheless, the lessons are there to be learnt and as a result, hedge fund risk management should be stronger for it “The most important lesson we learned was which methods do not work. We realised that most hedge funds are not ‘chameleon’ enough (adaptable) and did not change their processes, technology and infrastructure enough.”

Referring to the bull period of 2003 to 2007, Sylzar believes that it is during a bull run when risk managers should be most aware since the market is behaving in a more reckless manner, whereas bear runs bring out the naturally cautious side of people.

Post-2008, what practices should hedge fund risk managers utilise according to Syzlar?

A holistic approach (as was outlined in the PROHEDGE preview article).

Identify hedge fund specific risk or idiosyncratic risk.

Practice risk management across the entire investment lifecycle, from pre-trade to post-trade and beyond.

Risk and performance management should be practiced together and linked as a job function in one department.

Analyse tail risk and crisis management actively.

Drilling into the ‘holistic’ approach to risk management, Syzlar recommends a number of measures and calculations that must be tracked by a diligent risk manager:

Multivariate stress tests. “We constantly hear economists explaining why their predictions were wrong, therefore when we stress test, we need to understand every dimension.”

Understand the degearing process.

Regular performance analysis and understanding of our “alpha sources”.

VaR.

Analysis of short-term, medium and long-term risk.

Factor contribution analysis. Risk managers should utilise both statistical and fundamental factor models

Ability to assess the impact of changing correlations between factors.

Finally, there should be a “validation process” for the all the above measures to ensure that results are accurate and realistic.

The recent introduction of numerous regulations in all jurisdictions has also impacted on risk management practices. Today, many regulators require risk measurements to be reported as part of regulatory compliance, this will certainly be the case when AIFMD is introduced in Europe next year. Syzlar warns that risk managers should not be distracted by regulatory reporting and remember why risk management is necessary. “Risk management should not happen because of a regulation, it should be organic within a firm. Hedge funds should monitor risk because they want to understand it.”