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Hedge Funds & Risk Management


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This presentation presents the various risk management tools employed by the hedge fund industry . Drawing from MFA’s white paper collaboration with BNY Mellon and HedgeMark, this presentation highlights new industry practices and the evolving approach to risk management within the industry.

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Published in: Economy & Finance
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Hedge Funds & Risk Management

  2. 2. Risk Management Contents Executive Summary: In the financial markets, risk has always been a factor. Hedge funds’ main objective and unique attribute is their ability to minimize risk while maximizing returns. Over the past few years, hedge funds’ approach to risk management has evolved and strengthened. This presentation provides an overview of the ways hedge funds deal with certain risk types as well as hedge funds’ new and evolving internal protocol for risk management. Table of Contents: Risk in the Marketplace 3 Risk Types     Volatility Risk Commodity Risk Event Risk Tail Risk 4 5 6 7 Hedge Funds & Risk Management 8 Hedge Funds’ Evolving Approach to Risk 9 2
  3. 3. Risk Management Risk in the Marketplace Risk has always been a factor in financial markets, and risk management has never been as important as it is today. Hedge funds originated as an investment platform to manage risk and deliver reliable returns over time. The following slides provide examples of types of risk in the marketplace and the ways hedge funds help manage those risks. 3
  4. 4. Risk Management Risk Types Volatility Risk Increased price fluctuations in the marketplace cause volatility risk. Volatility risk is usually managed through portfolio diversification by asset class, geography, market sector, and strategy. It can emerge on different levels under extreme market conditions in which correlations between asset classes and strategies tend to change and often converge. Managers may hedge volatility risk through use of financial derivatives. 4
  5. 5. Risk Management Risk Types Commodity Risk Commodity risk refers to the risk of rising or falling commodity prices that may result from supply and demand imbalances, changing spending patterns, or changing input costs. Commodity risk can be hedged through futures and forward commodity contracts. Futures and forward contracts have the same basic function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. The difference is that futures contracts are standardized contracts that are exchange-traded, and forward contracts are private agreements between two parties. 5
  6. 6. Risk Management Risk Types Event Risk Event risks are those unusual circumstances in which large-scale swings occur in capital markets. These may arise from unpredictable events such as terrorist attacks, natural disasters, unusual weather patterns, or oil supply shocks. To analyze extreme event risk, a hedge fund manager should employ a series of hypothetical scenarios that are relevant to the particular portfolio. Examples of market stress events may include rapid equity declines and credit-spread widening or a period of rapid equity advances and credit tightening. Mangers should conduct appropriate stress testing based on the current portfolio exposures and specifics. 6
  7. 7. Risk Management Risk Types Tail Risk Tail risk is the risk of an asset - or portfolio of assets – experiencing a significant change from its current price. Tail-risk strategies are basically designed to thrive in the worst market conditions. Tail risk hedging can be an appropriate strategy to help investors pursue their objectives, without having to significantly adjust their risk and/or return expectations after a market crisis. There are a number of ways investors can employ tail risk hedging, including: • • Source: Pimco Education Series limiting the risk in your asset allocation by weighting your portfolio to less volatile sectors holding your asset allocation constant and complementing it with lower-risk strategies. 7
  8. 8. Risk Management Hedge Funds & Risk Management In addition to developing unique methods for combatting risk in the marketplace, hedge funds have also strengthened their internal risk management protocol. A 2012 report by BNY Mellon, HedgeMark, and the Managed Funds Association surveyed hedge funds and their investors about their evolving approach to risk. The following slides detail some of the important risk management practices employed by hedge funds today. Source: BNY Mellon 2012 8
  9. 9. Risk Management Hedge Funds’ Evolving Approach to Risk Hedge funds have increasingly strengthened their internal risk management protocols, for example: • Today, 79% of firms separate their risk manager and fund manager functions to ensure independent oversight. • 84% of hedge funds now use off-the-shelf risk analytics that form part of the portfolio management or trading system – hedge funds are looking to a wider array of sources to model their portfolios and protect against risk of all types. • Over 91% of hedge funds rely on a third-party risk management administrator for fund reporting and safe keeping to help boost investor confidence in these areas. Source: BNY Mellon 2012 9
  10. 10. Risk Management Hedge Funds’ Evolving Approach to Risk • • Many funds have elevated risk officers and designated them with the position of Chief Risk Officer, placing them on par with other senior executive positions like the General Counsel and Chief Financial Officer. • Better firm-wide consolidated risk reporting has become a top priority. In 2011, hedge funds spent more than $2 billion on implementing risk systems and infrastructure. • Source: BNY Mellon 2012 60% of larger hedge fund managers now have an employee (or employees) dedicated solely to risk management - many managers stated that before 2008 this role was not a separate function. The financial crisis of 2008 provided managers with a new body of historical data to create relevant, authentic “what if” scenarios. As a result, risk systems now have more data available that includes numerous examples of highly volatile risk periods to inform strategies moving forward. 10