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Hedge Funds Prioritise Risk Management

Date: Wednesday, November 21, 2012
Author: Ahila Karan, ProHedge.co.uk

Hedge funds have had to reassess their risk management process in order to restore confidence in the industry. To attract investors and appease regulators funds have reprioritised risk management, changing the way their organisation is structured and even overhauling their investment strategy.

Internal structures within hedge funds have changed, as funds prioritise risk management as a key business function. A BNY Mellon survey finds hedge funds are implementing new systems to bolster risk analysis; 84% of surveyed hedge funds now hold diverse risk models to consolidate external and in-house risk assessments.

Previously, it was sufficient for fund managers to invest their own money in the fund to inspire investor confidence and align manager and investor interests. This strategy did not protect investors during the crisis. Today, in response to investor caution, risk analysis is now carried out independently of fund management; evidence shows the majority of funds keep investment and internal risk functions separate, and funds also employ external risk reporting bodies to bolster results. Ensuring neutrality and reliable reporting is just one emerging area of risk protection.

Top of the agenda

Post-crisis investors remain mostly anxious about illiquidity and its catalytic effect on market conditions. Consequently, focus shifted to hedging against tail risk, to keep portfolios afloat in the worst market conditions. There are two main hedging strategies for tail risk: 1) alter weightings in asset allocation towards less volatile sectors and 2) retain asset allocation but move to low risk strategies. 55% of surveyed fund managers changed their asset allocation weightings (strategy 1) to handle liquidity risks, choosing to substitute between cash and equity.

Cash, the more liquid of the two assets, ultimately removes the investor from the gamble; now there is no risk of loss. Averse to tail risk initiated by illiquidity, 40% of hedge funds now use this cash holding strategy, compared to 5% before the crisis. Under the cash/equity strategy: funds replace equity with cash holdings to mitigate liquidity risk; and then hold more equity if risk appetite is increased. For example, liquidity fears rose in April in light of EU sovereign debt concerns therefore cash levels increased to remedy liquidity risk. Then, in September these fears eased, more European equities were purchased, and overall cash holdings fell from 4.5 to 4.3%. The ‘cash rule’ states that funds will keep cash levels within a 3.5 – 4.5% band; too much cash limits a fund’s core investment activities; and risk protection becomes insufficient with too little.

A new direction

Despite the failure of Multi-Strategy (MS) funds during the crisis, recently investors have returned to MS funds, attracted by the resilience to volatile markets. To safeguard against increased price fluctuations – i.e. volatility risk – MS funds diversify both asset types and strategies; this requires efficient capital rotation and knowledge of market trends and cyclicality. Greater MS fund investments display renewed confidence in fund managers’ abilities and also a demand for volatility risk management.

Further confidence in fund managers is demonstrated by the move away from Fund of Funds (FoF) towards MS funds. However, in this attempt to avoid the additional fees of FoFs, investors expose themselves to single manager risk. Whilst FoFs involve multiple fund managers, the performance of an MS fund rests with one manager’s decisions. This move suggests recovered trust in fund managers since the Madoff scandal, or even negligence in this area of risk management.

Concerns over illiquidity remain at the forefront of investor decision making; updated infrastructure and a return to an old-fashioned cash holding strategy mark significant evolutions in risk management.