Managing Risk in Alternative
Investment Strategies: Hedge Funds

Alternative Investment Strategies
(AIS) exist across a variety of
different asset classes

(including equity, fixed income and
foreign exchange) on both a
directional and non-directional
basis.

Hedge Funds, the classic example of
an AIS investor take advantage of a
flexible approach to...

multiple asset classes, trading styles,
markets, leverage, short-selling and
liquidity.

Typical investors include high net
worth and institutional investors i.e.

pension funds and endowments
(longer term view, high levels of risk
aversion, who emphasis stability of
investment returns).

An understanding about how past
returns were generated is
imperative to successful asset
allocation.

Past performance may not
evidence potential risk factors.

Access to regular information about
a manager’s trading activities allows
not only for changes in style,

but can also help to quickly
recognize and address any undesired
bets or leverage increases.

Investors must understand how
numerous macroeconomic factors
influence the performance of the
individual strategies.

The systematic market risk of the
individual strategy sector is what
earns most strategies their return in
the form of a risk premium.

In pursuing sector and manager
diversification,

an investor needs a detailed
understanding of the correlations
between strategy sectors and asset
classes in different market
environments.

A thorough understanding of the
market conditions that might reduce
a manager’s edge...

would have enabled investors to exit
Long Term Capital Management
prior to its collapse.

Reported NAVs often do not take
into account the liquidity of open
positions,

especially when a position is large
compared to daily trading volume of
the asset (such as that of Distressed
Debt).

Suitable sector allocation can be
ensured through clear investment
objectives, performance targets and
well defined risk parameters.

Hedge fund managers monitor the
interrelated exposure to market risk
(including asset risk),

funding liquidity risk, credit risk
(debt investments, counter-party
risk) and operational risk.

Investor concerns include broad and
diverse asset risk (heterogeneity),

lack of transparency, and low
liquidity (relatively long redemption
periods often at the option of AIS
managers).

In order to cope with the risk of a
severe loss, continuous monitoring
of exposures and risk is necessary,

permitting the early identification of
any deviations from a stated
strategy.

Effective risk management
begins with the ability to control.

“Blackbox” investing is more and
more unsuitable from either a
fiduciary or principal perspective.

The threat of being copied or
actively traded against had come
largely from the dealer community

and the investment bank proprietary
trading desks rather than from AIS
allocators or direct investors.

This risk may be abating due to the
Volcker Rule, or simply moving to
newer or different platforms.

However, increased risk resulting
from previously known and
accepted exposures, cannot be
entirely eliminated.

In order to present a clear edge, a
manager must be willing to openly
explain to investors any changes in
its portfolio risk.

Managing Risk in Alternative
Investment Strategies: Hedge Funds