3. COVERAGECOVERAGE
• What is financial riskWhat is financial risk
• Financial risk management definedFinancial risk management defined
• Risk Management for Hedge FundsRisk Management for Hedge Funds
Hedge Fund Managers PerspectiveHedge Fund Managers Perspective
Institutional Investors PerspectiveInstitutional Investors Perspective
• Types of Hedge Fund RiskTypes of Hedge Fund Risk
• Issues associated with the investment processIssues associated with the investment process
4. • What is Financial Risk?What is Financial Risk?
Financial risk is uncertainty in financial transactionsFinancial risk is uncertainty in financial transactions
undertaken by the firm. This uncertainty is in theundertaken by the firm. This uncertainty is in the
form of future financial abilities of the issuer to payform of future financial abilities of the issuer to pay
stockholders and creditor’s principal and interest.stockholders and creditor’s principal and interest.
• Financial Risk Management Defined:Financial Risk Management Defined:
An assessment of the possibility that a givenAn assessment of the possibility that a given
investment or loan will fail to bring a return and mayinvestment or loan will fail to bring a return and may
result in a loss of the original investment or loan andresult in a loss of the original investment or loan and
take the measures to minimize or reduce the risktake the measures to minimize or reduce the risk
probabilities associated with the investment decisionprobabilities associated with the investment decision
which the firm make on behalf of investors to earnwhich the firm make on behalf of investors to earn
for them the expected returns.for them the expected returns.
5. Despite ongoing concerns about the lack of transparency and potentialDespite ongoing concerns about the lack of transparency and potential
instabilities of hedge fund investment companies, the hedge fund industryinstabilities of hedge fund investment companies, the hedge fund industry
continues to grow at a rapid pace which is evident from the asset sizecontinues to grow at a rapid pace which is evident from the asset size
under management to the tune of US $ 1.13 trillion.under management to the tune of US $ 1.13 trillion.
Unlike equities, fixed income instruments, and real estate–asset classesUnlike equities, fixed income instruments, and real estate–asset classes
each defined by a common set of legal, institutional, and statisticaleach defined by a common set of legal, institutional, and statistical
properties–“alternative investments” is a mongrel categorization thatproperties–“alternative investments” is a mongrel categorization that
includes private equity, risk arbitrage, commodity futures, convertibleincludes private equity, risk arbitrage, commodity futures, convertible
bond arbitrage, emerging market equities, statistical arbitrage, foreignbond arbitrage, emerging market equities, statistical arbitrage, foreign
currency speculation, and many other strategies, securities, and styles.currency speculation, and many other strategies, securities, and styles.
Therefore, the need for a set of risk management protocols specificallyTherefore, the need for a set of risk management protocols specifically
designed for hedge fund investments has never been more pressing. Partdesigned for hedge fund investments has never been more pressing. Part
of the gap between institutional investors and hedge fund managers isof the gap between institutional investors and hedge fund managers is
the very different perspectives that these two groups have on thethe very different perspectives that these two groups have on the
investment process.investment process.
SCENARIO OF HEDGE FUND INDUSTRY
6. Manager and Institutional Investors – Risk PerspectivesManager and Institutional Investors – Risk Perspectives
ManagerManager Institutional InvestorsInstitutional Investors
Desecration in investment decisions.Desecration in investment decisions.
Understanding of the investment processUnderstanding of the investment process
and the risk is very important.and the risk is very important.
Strategy is highly proprietary and mangersStrategy is highly proprietary and mangers
intellectual property so no much disclosure.intellectual property so no much disclosure.
Not only the return other factors alsoNot only the return other factors also
counts e.g. risk management, performancecounts e.g. risk management, performance
against the benchmark, peer comparisonagainst the benchmark, peer comparison
etc.etc.
Return is the ultimate objectives andReturn is the ultimate objectives and
purpose.purpose.
Risk management and the transparencyRisk management and the transparency
are critical factors.are critical factors.
General partner is the fund.General partner is the fund.
They should know the investment processThey should know the investment process
very well as this class have to comply withvery well as this class have to comply with
the various state and fiscal laws.the various state and fiscal laws.
Regulators are the hurdles in theRegulators are the hurdles in the
performance.performance.
Risk management is not central or much ofRisk management is not central or much of
the importance.the importance.
7. Variety of risk management techniques are been used by the hedge fundVariety of risk management techniques are been used by the hedge fund
managers and the respective class of investors while doing the businessmanagers and the respective class of investors while doing the business
and investing respectively. Some of them are as follows:and investing respectively. Some of them are as follows:
• Value at RiskValue at Risk
• Risk MetricsRisk Metrics
• ConvexityConvexity
• BetaBeta
• LeveragesLeverages
It is to be remembered that the alternative investment like hedge fundsIt is to be remembered that the alternative investment like hedge funds
are not suitable for all investors, one should know his own risk appetiteare not suitable for all investors, one should know his own risk appetite
and then only opt for such type of investment alternative.and then only opt for such type of investment alternative.
RISK MEASUREMENT TECHNIQUES
8. RISK – TYPESRISK – TYPES
Liquidity Risk:Liquidity Risk:
Liquidity risk arises on the assets side, when the positions cannot be liquidatedLiquidity risk arises on the assets side, when the positions cannot be liquidated
quickly without incurring transaction costs. It also arises on the liabilities side,quickly without incurring transaction costs. It also arises on the liabilities side,
either from the leverage (debt), or from potential investor redemptions (equity).either from the leverage (debt), or from potential investor redemptions (equity).
Typically, funds with greater asset liquidity risk impose longer lockup periods forTypically, funds with greater asset liquidity risk impose longer lockup periods for
investors in order to balance liquidity risk on both sides of their balance sheet.investors in order to balance liquidity risk on both sides of their balance sheet.
On the asset side, liquidity risk is a function of the size of the positions as well as ofOn the asset side, liquidity risk is a function of the size of the positions as well as of
the price impact of a given size trade for the instrument. Some categories of hedgethe price impact of a given size trade for the instrument. Some categories of hedge
funds have intrinsic liquidity risk because the instruments they use are thinlyfunds have intrinsic liquidity risk because the instruments they use are thinly
traded, implying a large price impact for most trades. This is the case withtraded, implying a large price impact for most trades. This is the case with
convertible bonds or distressed securities. In this case, liquidity risk arises even forconvertible bonds or distressed securities. In this case, liquidity risk arises even for
small funds. Liquidity risk, however, is also an issue when the fund positions growsmall funds. Liquidity risk, however, is also an issue when the fund positions grow
very large, even in liquid markets.very large, even in liquid markets.
Liquidity risk is difficult to factor into the usual value-at-risk (VAR) models. Usually,Liquidity risk is difficult to factor into the usual value-at-risk (VAR) models. Usually,
VAR models loosely account for liquidity risk by extending the horizon for lessVAR models loosely account for liquidity risk by extending the horizon for less
liquid assets. This is a totallyliquid assets. This is a totally ad hocad hoc approach, however. Accounting for potentialapproach, however. Accounting for potential
losses due to asset liquidation requires a price impact function, which is difficult tolosses due to asset liquidation requires a price impact function, which is difficult to
estimate. Optimal liquidation strategies should balance the direct cost of fastestimate. Optimal liquidation strategies should balance the direct cost of fast
liquidation against the risk of keeping open positions.liquidation against the risk of keeping open positions.
9. Liquidity Risk Cont.Liquidity Risk Cont.
Instrument liquidity risk creates another problemInstrument liquidity risk creates another problem
which is that of stale prices. Say that the reportingwhich is that of stale prices. Say that the reporting
period for net asset values (NAV) is the end of eachperiod for net asset values (NAV) is the end of each
month. If transaction prices are not observed at themonth. If transaction prices are not observed at the
end of the month, the valuation may be using a priceend of the month, the valuation may be using a price
from a trade that occurred in the middle of thefrom a trade that occurred in the middle of the
month, creating measurement errors in the reportedmonth, creating measurement errors in the reported
NAVs. This is a minor nuisance, but does notNAVs. This is a minor nuisance, but does not
necessarily create a systematic bias in the NAVs.necessarily create a systematic bias in the NAVs.
Investors, however, should make sure the hedgeInvestors, however, should make sure the hedge
fund manager is not manipulating asset values tofund manager is not manipulating asset values to
overstate the fund’s performance.overstate the fund’s performance.
10. Market Risk:Market Risk:
Market risk is exposure to the uncertain market value of a portfolio. AMarket risk is exposure to the uncertain market value of a portfolio. A
trader holds a portfolio of commodity forwards. He knows what its markettrader holds a portfolio of commodity forwards. He knows what its market
value is today, but she is uncertain as to its market value a week fromvalue is today, but she is uncertain as to its market value a week from
today. Market risk is the inherent in case of the trading into the financialtoday. Market risk is the inherent in case of the trading into the financial
markets but the hedge funds are known for their market neutralmarkets but the hedge funds are known for their market neutral
strategies which try to isolate their own product portfolio from the marketstrategies which try to isolate their own product portfolio from the market
direction.direction.
Market risk is managed with a short-term focus. Long-term losses areMarket risk is managed with a short-term focus. Long-term losses are
avoided by avoiding losses from one day to the next. On a tactical level,avoided by avoiding losses from one day to the next. On a tactical level,
traders and portfolio managers employ a variety of risk metrics —traders and portfolio managers employ a variety of risk metrics —
duration and convexity, the Greeks, beta, etc.—to assess theirduration and convexity, the Greeks, beta, etc.—to assess their
exposures. These allow them to identify and reduce any exposures theyexposures. These allow them to identify and reduce any exposures they
might consider excessive. On a more strategic level, organizationsmight consider excessive. On a more strategic level, organizations
manage market risk by applying risk limits to traders' or portfoliomanage market risk by applying risk limits to traders' or portfolio
managers' activities. Increasingly, value-at-risk is being used to definemanagers' activities. Increasingly, value-at-risk is being used to define
and monitor these limits. Some organizations also apply stress testing toand monitor these limits. Some organizations also apply stress testing to
their portfolios.their portfolios.
11. Credit Risk:Credit Risk:
Credit risk is risk due to uncertainty in a counterparty's (also called anCredit risk is risk due to uncertainty in a counterparty's (also called an
obligor's or credit's) ability to meet its obligations. Because there areobligor's or credit's) ability to meet its obligations. Because there are
many types of counterparties—from individuals to sovereignmany types of counterparties—from individuals to sovereign
governments—and many different types of obligations—from auto loansgovernments—and many different types of obligations—from auto loans
to derivatives transactions—credit risk takes many forms. Institutionsto derivatives transactions—credit risk takes many forms. Institutions
manage it in different ways.manage it in different ways.
In assessing credit risk from a single counterparty, an institution mustIn assessing credit risk from a single counterparty, an institution must
consider three issues:consider three issues:
Default probabilityDefault probability:: What is the likelihood that the counterparty willWhat is the likelihood that the counterparty will
default on its obligation either over the life of the obligation or overdefault on its obligation either over the life of the obligation or over
some specified horizon, such as a year? Calculated for a one-yearsome specified horizon, such as a year? Calculated for a one-year
horizon, this may be called the expectedhorizon, this may be called the expected defaultdefault frequency.frequency.
CreditCredit exposureexposure:: In the event of a default, how large will theIn the event of a default, how large will the
outstanding obligation be when the default occurs?outstanding obligation be when the default occurs?
RecoveryRecovery raterate:: In the event of a default, what fraction of the exposureIn the event of a default, what fraction of the exposure
may be recovered through bankruptcy proceedings or some othermay be recovered through bankruptcy proceedings or some other
form of settlement?form of settlement?
12. Market Neutral Strategies – A Risk PerspectiveMarket Neutral Strategies – A Risk Perspective
U.S. Equity Market Neutral strategies are viewed to be among the mostU.S. Equity Market Neutral strategies are viewed to be among the most
straightforward and easily understandable types of hedge fund. Thesestraightforward and easily understandable types of hedge fund. These
strategies are designed to take advantage of the spread between returnsstrategies are designed to take advantage of the spread between returns
of attractive stocks (on the long side) and unattractive stocks (on theof attractive stocks (on the long side) and unattractive stocks (on the
short side). A manager's ability to capture this spread is a function ofshort side). A manager's ability to capture this spread is a function of
stock selection skill as well as other lesser known or understoodstock selection skill as well as other lesser known or understood
considerations.considerations.
Investors are increasingly turning to hedge funds in an effort to maintainInvestors are increasingly turning to hedge funds in an effort to maintain
satisfactory returns while reducing portfolio volatility. Hedge fundssatisfactory returns while reducing portfolio volatility. Hedge funds
typically are highlytypically are highly uncorrelateduncorrelated with traditional asset classes andwith traditional asset classes and
therefore provide good diversification benefits along with the potential fortherefore provide good diversification benefits along with the potential for
very strong investment returns. Long-short market neutral U.S. equityvery strong investment returns. Long-short market neutral U.S. equity
strategies are among the more popular hedge funds for achieving thisstrategies are among the more popular hedge funds for achieving this
goal. These strategies typically use stock selection to capture excessgoal. These strategies typically use stock selection to capture excess
returns while targeting a beta exposure of zero. By investing both longreturns while targeting a beta exposure of zero. By investing both long
and short, the manager can neutralize market exposure while doublingand short, the manager can neutralize market exposure while doubling
the potential for excess return. Investors find varied uses for long-shortthe potential for excess return. Investors find varied uses for long-short
market neutral strategies within their portfolios.market neutral strategies within their portfolios.
13. Broadly, there are some misperceptions that follow theBroadly, there are some misperceptions that follow the
strategy. One is the opinion that long-short market neutralstrategy. One is the opinion that long-short market neutral
strategies somehow provide a free lunch because of thestrategies somehow provide a free lunch because of the
double alpha, or return, of the strategy. What is oftendouble alpha, or return, of the strategy. What is often
forgotten is the double omega, or active risk, associated withforgotten is the double omega, or active risk, associated with
the strategy. This means that while a skilled manager maythe strategy. This means that while a skilled manager may
have double the positive value-added, an unskilled managerhave double the positive value-added, an unskilled manager
may have double the negative value-added.may have double the negative value-added.
When evaluating market neutral strategies theseWhen evaluating market neutral strategies these
misconceptions and other potential risks need to bemisconceptions and other potential risks need to be
understood and explored rigorously. Generally, the risks fallunderstood and explored rigorously. Generally, the risks fall
into four categories: investment process, implementation,into four categories: investment process, implementation,
personnel, and firm.personnel, and firm.
15. Issues Associated with Investment Process:Issues Associated with Investment Process:
The Manager's JudgmentThe Manager's Judgment
The greatest risk for a long-short market neutral strategy is that the source ofThe greatest risk for a long-short market neutral strategy is that the source of
return will vanish. Ultimately, the success of most long-short market neutralreturn will vanish. Ultimately, the success of most long-short market neutral
strategies comes down to stock selection. Therefore, if the stock ranking processstrategies comes down to stock selection. Therefore, if the stock ranking process
is invalidated, the manager's edge is gone. Over the years, managers haveis invalidated, the manager's edge is gone. Over the years, managers have
experienced periods when their process was "out of favor" in times when marketexperienced periods when their process was "out of favor" in times when market
conditions or structure had changed. Sometimes these changes reversed and theconditions or structure had changed. Sometimes these changes reversed and the
approach returned to favor, sometimes they did not.approach returned to favor, sometimes they did not.
Changes in Market StructureChanges in Market Structure
Changes to market structure can also be an impediment to manager success. ForChanges to market structure can also be an impediment to manager success. For
example, the emergence of new industries needs to be taken into accountexample, the emergence of new industries needs to be taken into account
because as they grow, maintaining neutrality to them becomes an issue. Considerbecause as they grow, maintaining neutrality to them becomes an issue. Consider
the rise of the Internet industry. Companies now classified as Internets werethe rise of the Internet industry. Companies now classified as Internets were
previously in market segments as diverse as financial services, media andpreviously in market segments as diverse as financial services, media and
computer hardware. Because they looked expensive relative to their then industrycomputer hardware. Because they looked expensive relative to their then industry
counterparts, many long-short market neutral funds held them short. In aggregatecounterparts, many long-short market neutral funds held them short. In aggregate
this left the strategy short the Internet industry at precisely the wrong time.this left the strategy short the Internet industry at precisely the wrong time.
Bringing them together into the same industry allowed for the comparison of likeBringing them together into the same industry allowed for the comparison of like
companies. The same experience is occurring with genomics companies. Thesecompanies. The same experience is occurring with genomics companies. These
had been classified in the drug industry, but they are behaving differently from thehad been classified in the drug industry, but they are behaving differently from the
more traditional drug companies and should be reclassified into their own industry.more traditional drug companies and should be reclassified into their own industry.
16. Business CategorizationBusiness Categorization
The phenomenon goes beyond just identifying new industries. It is also important toThe phenomenon goes beyond just identifying new industries. It is also important to
understand a company's business in order to insure the appropriate industry classification.understand a company's business in order to insure the appropriate industry classification.
Corning exemplifies this matter as it began in the late 1800's as Corning Flint Glass, aCorning exemplifies this matter as it began in the late 1800's as Corning Flint Glass, a
consumer products company. Consumer products remained an appropriate category for thisconsumer products company. Consumer products remained an appropriate category for this
company until, in 1971, it developed optical fiber that enables voice, video and data to becompany until, in 1971, it developed optical fiber that enables voice, video and data to be
sent via lasers. This was a fundamental shift in the company's business that was notsent via lasers. This was a fundamental shift in the company's business that was not
reflected immediately in its industry classification. The bottom-line is that businesses andreflected immediately in its industry classification. The bottom-line is that businesses and
industries emerge and change, and investment managers must be aware of these changesindustries emerge and change, and investment managers must be aware of these changes
in order to be successful.in order to be successful.
Incomplete Information and ValuationIncomplete Information and Valuation
As we look to the future there are many areas that could influence a manager's ability to addAs we look to the future there are many areas that could influence a manager's ability to add
value. One example involves the relationship between investment bankers and brokeragevalue. One example involves the relationship between investment bankers and brokerage
houses. Will polluted information flow into the market from brokers who are swayed byhouses. Will polluted information flow into the market from brokers who are swayed by
business conducted on the other side of the Chinese wall? Another example is the ongoingbusiness conducted on the other side of the Chinese wall? Another example is the ongoing
concern about the quality of earnings and cash flow information. Do they really reflect theconcern about the quality of earnings and cash flow information. Do they really reflect the
value of the company or are they misleading as a result of pension accounting and options?value of the company or are they misleading as a result of pension accounting and options?
In conclusion, managers must be aware of the influences on their approach, fromIn conclusion, managers must be aware of the influences on their approach, from
accounting manipulations to changes in industry structure and take steps to manage theseaccounting manipulations to changes in industry structure and take steps to manage these
exposures including incorporating dynamic approaches to stock selection, portfolioexposures including incorporating dynamic approaches to stock selection, portfolio
construction and industry classifications. The key to success is staying ahead of the curveconstruction and industry classifications. The key to success is staying ahead of the curve
and investors must take care to identify the manager who can accomplish this.and investors must take care to identify the manager who can accomplish this.
A final, though often overlooked, area of investment process risk goes beyond individualA final, though often overlooked, area of investment process risk goes beyond individual
managers. Investors should be aware of how their long-short managers generate theirmanagers. Investors should be aware of how their long-short managers generate their
excess returns and whether all use the similar techniques. If that is the case, diversificationexcess returns and whether all use the similar techniques. If that is the case, diversification
of process risk is called for within their alternatives category.of process risk is called for within their alternatives category.
17. Implementation:Implementation:
Correctly selecting stocks is only half the job when it comes to managing long-Correctly selecting stocks is only half the job when it comes to managing long-
short market neutral strategies. Implementation holds additional challenges for theshort market neutral strategies. Implementation holds additional challenges for the
manager and additional considerations for the investor. First, there are the issuesmanager and additional considerations for the investor. First, there are the issues
of liquidity, capacity and ability to borrow, and then there are those related toof liquidity, capacity and ability to borrow, and then there are those related to
interaction with prime brokers and traders.interaction with prime brokers and traders.
Implementation RisksImplementation Risks
Capacity, liquidity and ability to borrow risks are other areas that investors shouldCapacity, liquidity and ability to borrow risks are other areas that investors should
evaluate when considering long-short market neutral managers. A major factor inevaluate when considering long-short market neutral managers. A major factor in
long-short market neutral strategies is lack of capacity on the short side. Capacitylong-short market neutral strategies is lack of capacity on the short side. Capacity
constraints arise, as with small cap strategies, as a result of the stock universeconstraints arise, as with small cap strategies, as a result of the stock universe
and fund size. In addition, liquidity may affect the portfolio manager's ability toand fund size. In addition, liquidity may affect the portfolio manager's ability to
implement the strategy if the fund is either so large that it cannot short positions inimplement the strategy if the fund is either so large that it cannot short positions in
the necessary size or if it needs to short positions that are not in good supplythe necessary size or if it needs to short positions that are not in good supply
(generally in the small cap range).(generally in the small cap range).
Along with liquidity, it may be difficult to borrow certain securities, especiallyAlong with liquidity, it may be difficult to borrow certain securities, especially
names that are not typically found in large institutional funds. The bulk ofnames that are not typically found in large institutional funds. The bulk of
institutional equity assets, which form the lion's share of security lending assets,institutional equity assets, which form the lion's share of security lending assets,
are invested in large cap companies. By identifying an appropriate inevitableare invested in large cap companies. By identifying an appropriate inevitable
universe, investment managers can avoid many of the issues of capacity, liquidityuniverse, investment managers can avoid many of the issues of capacity, liquidity
and ability to borrow within their long-short market neutral strategies.and ability to borrow within their long-short market neutral strategies.
18. Broker SelectionBroker Selection
Selection of the prime broker is an important decision because the primeSelection of the prime broker is an important decision because the prime
broker plays an integral role in the day to day management of the long-broker plays an integral role in the day to day management of the long-
short market neutral process. Criteria for selecting a prime brokershort market neutral process. Criteria for selecting a prime broker
include their internal and external access to stock on loan, industryinclude their internal and external access to stock on loan, industry
experience and resources. First, access to loaned stocks is critical toexperience and resources. First, access to loaned stocks is critical to
the effective implementation of the long-short strategy. If a managerthe effective implementation of the long-short strategy. If a manager
cannot short a desired security, there is a lost opportunity. Primecannot short a desired security, there is a lost opportunity. Prime
brokers should use electronic locates and other techniques to improvebrokers should use electronic locates and other techniques to improve
implementation. Second, expertise in the operational and managementimplementation. Second, expertise in the operational and management
issues associated with long-short strategies is also crucial. Experiencedissues associated with long-short strategies is also crucial. Experienced
prime brokers are often able to help managers avoid potential executionprime brokers are often able to help managers avoid potential execution
pitfalls. Third, information management is a significant part of what thepitfalls. Third, information management is a significant part of what the
prime broker does; therefore, a strong support structure is required. Aprime broker does; therefore, a strong support structure is required. A
good prime broker can trouble-shoot potential problems and act quicklygood prime broker can trouble-shoot potential problems and act quickly
when problems arise. They are also efficient and timely when it comeswhen problems arise. They are also efficient and timely when it comes
to reporting. Advanced technology (including, though not limited to,to reporting. Advanced technology (including, though not limited to,
internet reporting and trading analytics) is an essential component ofinternet reporting and trading analytics) is an essential component of
this. A final consideration is security. In this age of freely flowingthis. A final consideration is security. In this age of freely flowing
information, it is important that client data are protected by the primeinformation, it is important that client data are protected by the prime
broker. Many prime brokers provide individual security identifications tobroker. Many prime brokers provide individual security identifications to
each member of the portfolio management team to ensure tight security.each member of the portfolio management team to ensure tight security.
19. Personnel:Personnel:
Personnel risk includes the risk that a manager is not qualified or is qualified butPersonnel risk includes the risk that a manager is not qualified or is qualified but
will leave the firm. Experience and competence are difficult to discern becausewill leave the firm. Experience and competence are difficult to discern because
they are often masked by the aura of age, education, and industry exposure.they are often masked by the aura of age, education, and industry exposure.
Although these provide an investor with a level of comfort, they may not tell theAlthough these provide an investor with a level of comfort, they may not tell the
whole story. In today's dynamic environment it may be more important to considerwhole story. In today's dynamic environment it may be more important to consider
a person's ability to stay on the leading edge rather than whether they used to bea person's ability to stay on the leading edge rather than whether they used to be
on the leading edge.on the leading edge.
Incentives and Personnel LoyaltyIncentives and Personnel Loyalty
Once comfortable with a manager, you need to make sure that person isOnce comfortable with a manager, you need to make sure that person is
motivated to stay at the firm. A manager will move on if compensation is notmotivated to stay at the firm. A manager will move on if compensation is not
competitive, if the surroundings and corporate culture are not satisfying or if thecompetitive, if the surroundings and corporate culture are not satisfying or if the
future is uncertain - for the firm or the manager. Investors can typically get afuture is uncertain - for the firm or the manager. Investors can typically get a
sense for these issues by asking specific questions about the compensationsense for these issues by asking specific questions about the compensation
structure and the amount of time spent on the road, and it is always useful to visitstructure and the amount of time spent on the road, and it is always useful to visit
the manager's site during the due diligence process to make an impression aboutthe manager's site during the due diligence process to make an impression about
the other issues. Keep in mind, there may be two sides to an issue, particularlythe other issues. Keep in mind, there may be two sides to an issue, particularly
compensation. Often it is believed that if managers invest in their own long-shortcompensation. Often it is believed that if managers invest in their own long-short
market neutral portfolio they will work harder to provide excess returns. There maymarket neutral portfolio they will work harder to provide excess returns. There may
be some positive motivation, but there may also be negative motivation since abe some positive motivation, but there may also be negative motivation since a
manager is more willing to take chances in order to recognize superior returns. Ifmanager is more willing to take chances in order to recognize superior returns. If
the compensation structure is fair and the manager is motivated in other ways,the compensation structure is fair and the manager is motivated in other ways,
regardless of personal participation, the manager's objectives should be in lineregardless of personal participation, the manager's objectives should be in line
with those of the participants.with those of the participants.
20. Firm:Firm:
The Commitment of the FirmThe Commitment of the Firm
Investors should also look at the investment management firm because the commitment ofInvestors should also look at the investment management firm because the commitment of
the firm to the strategy and the structure surrounding it are critical to its success.the firm to the strategy and the structure surrounding it are critical to its success.
Commitment shows in the form of resources to insure leading edge technology,Commitment shows in the form of resources to insure leading edge technology,
competitive compensation, and resources for investment research. In today's high techcompetitive compensation, and resources for investment research. In today's high tech
market environment speed and access to information is vital and without the necessarymarket environment speed and access to information is vital and without the necessary
data, technology and hardware investment opportunities may be lost. We've discusseddata, technology and hardware investment opportunities may be lost. We've discussed
manager compensation, however this is another way that a firm shows its support for themanager compensation, however this is another way that a firm shows its support for the
strategy.strategy.
A Firm's Internal Support StructureA Firm's Internal Support Structure
A solid firm structure is important to support the activities of the portfolio managementA solid firm structure is important to support the activities of the portfolio management
team. This support comes from many areas including sales/marketing support to keepteam. This support comes from many areas including sales/marketing support to keep
managers focused on day-to-day management instead of asset gathering, operationalmanagers focused on day-to-day management instead of asset gathering, operational
support to insure readily available portfolio, cash and trading data and, finally, compliancesupport to insure readily available portfolio, cash and trading data and, finally, compliance
support to assure careful monitoring and fulfillment of guidelines.support to assure careful monitoring and fulfillment of guidelines.
Structure can also be considered from the perspective of firm size. This attribute providesStructure can also be considered from the perspective of firm size. This attribute provides
benefits that are less visible. Larger firms are typically regulated more heavily andbenefits that are less visible. Larger firms are typically regulated more heavily and
therefore may exhibit less business risk. Additionally, larger firms have significanttherefore may exhibit less business risk. Additionally, larger firms have significant
bargaining power when it comes to trading and technology. The brokerage communitybargaining power when it comes to trading and technology. The brokerage community
tends to value prime brokerage and trading relationships with them because of the volumetends to value prime brokerage and trading relationships with them because of the volume
of trading generated and therefore they are more responsive and also provide moreof trading generated and therefore they are more responsive and also provide more
competitive pricing.competitive pricing.
21. • Long-short market neutral strategies offer many benefits relative toLong-short market neutral strategies offer many benefits relative to
traditional management approaches including diversificationtraditional management approaches including diversification
relative to traditional asset classes, attractive absolute return andrelative to traditional asset classes, attractive absolute return and
low volatility. To realize these benefits, investors must carefullylow volatility. To realize these benefits, investors must carefully
evaluate their manager choices keeping in mind a variety ofevaluate their manager choices keeping in mind a variety of
considerations including the long-term viability of their investmentconsiderations including the long-term viability of their investment
process, their ability to implement the approach, managerprocess, their ability to implement the approach, manager
qualification and motivation, and the management firm's strengthqualification and motivation, and the management firm's strength
and commitment to the strategy.and commitment to the strategy.
• Continued growth of the hedge fund industry is only sustainable ifContinued growth of the hedge fund industry is only sustainable if
these issues of liquidity and transparency are addressed in onethese issues of liquidity and transparency are addressed in one
way or another. Investors should be aware that liquidity risk mayway or another. Investors should be aware that liquidity risk may
be important for some categories of hedge funds and may lead tobe important for some categories of hedge funds and may lead to
biases in risk measures. Several methods can be used to correctbiases in risk measures. Several methods can be used to correct
for these biases. Finally, the development of risk measurementfor these biases. Finally, the development of risk measurement
providers and funds of funds demonstrates the importance ofproviders and funds of funds demonstrates the importance of
transparency for hedge funds.transparency for hedge funds.
ConclusionConclusion
23. The risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events. The
definition includes legal risk, which is the risk of loss resulting from
failure to comply with laws as well as prudent ethical standards
and contractual obligations. It also includes the exposure to
litigation from all aspects of an institution’s activities. The definition
does not include strategic or reputational risks.
What is Operational Risk?What is Operational Risk?
24. Operational risk losses are characterized by seven event factors
associated with:
• Internal fraud:
An act of a type intended to defraud, misappropriate property
or circumvent regulations, the law or company policy,
excluding diversity/discrimination events, which involve at
least one internal party.
• External fraud:
An act of a type intended to defraud, misappropriate property
or circumvent the law, by a third party.
• Employment practices and workplace safety:
An act inconsistent with employment, health or safety laws or
agreements, from payment of personal injury claims, or from
diversity/discrimination events.
What is Operational Risk Loss?What is Operational Risk Loss?
25. • Clients, products, and business practices:
An unintentional or negligent failure to meet a professional
obligation to specific clients (including fiduciary and suitability
requirements), or from the nature or design of a product.
• Damage to physical assets:
The loss or damage to physical assets from natural disaster or
other events.
• Business disruption and system failures:
Disruption of business or system failures.
• Execution, delivery, and process management:
Failed transaction processing or process management, from
What is Operational Risk Loss? (cont.)What is Operational Risk Loss? (cont.)
26. Hedge fund managers have long been aware of the need forHedge fund managers have long been aware of the need for
investors to conduct thorough due diligence when assessing theinvestors to conduct thorough due diligence when assessing the
merits of their investment strategy. Yet, over the past few years,merits of their investment strategy. Yet, over the past few years,
there has been an increasing focus on operational due diligencethere has been an increasing focus on operational due diligence
due to:due to:
• The increasing inflows of institutional capital into hedge funds.The increasing inflows of institutional capital into hedge funds.
• Some well publicized fraud cases which have caused lossesSome well publicized fraud cases which have caused losses
for even some of the most sophisticated investors in thefor even some of the most sophisticated investors in the
industry.industry.
• Regulators attention because of growth of assets class andRegulators attention because of growth of assets class and
increasing demand from retail investors and public pensionincreasing demand from retail investors and public pension
plans.plans.
THE NEED
27. Institutional investors are increasingly scrutinizing the operationalInstitutional investors are increasingly scrutinizing the operational
controls and procedures of hedge fund firms. Some of the itemscontrols and procedures of hedge fund firms. Some of the items
within these five key areas which sophisticated investors andwithin these five key areas which sophisticated investors and
hedge fund managers should focus on are:hedge fund managers should focus on are:
• The experience of operations personnelThe experience of operations personnel
• ComplianceCompliance
• Internal controls and proceduresInternal controls and procedures
• Portfolio pricingPortfolio pricing
• The quality of the service providersThe quality of the service providers
Five Key Operational ConsiderationsFive Key Operational Considerations
28. • Compulsory appointment of the CEO/CFO to look after theCompulsory appointment of the CEO/CFO to look after the
operational activities.operational activities.
• Ownership of operational activities with CEO/CFOOwnership of operational activities with CEO/CFO
• CEO/CFO to ensure sufficiency of operational and settlementCEO/CFO to ensure sufficiency of operational and settlement
staff in terms of number and the experiencestaff in terms of number and the experience
• CEO/CFO to look after operational activities carried on by theCEO/CFO to look after operational activities carried on by the
third party administrator if such activities have been outsourcedthird party administrator if such activities have been outsourced
by the hedge funds.by the hedge funds.
• Operations staff main activities would be to scrutinize the workOperations staff main activities would be to scrutinize the work
of the third party service provider in Detail.of the third party service provider in Detail.
Experience of Operations PersonnelExperience of Operations Personnel
29. Existence of the compliance manual to set out the complianceExistence of the compliance manual to set out the compliance
policies covering areas like personal trading, trade errors, knowpolicies covering areas like personal trading, trade errors, know
your customers etc.your customers etc.
Appointment of a Chief Compliance Officer to oversee theAppointment of a Chief Compliance Officer to oversee the
compliance function and the execution of the compliance policiescompliance function and the execution of the compliance policies
of the fund.of the fund.
The lack of adequate compliance policies and lack of controls toThe lack of adequate compliance policies and lack of controls to
effectively monitor and enforce such policies, may lead to futureeffectively monitor and enforce such policies, may lead to future
regulatory fallings.regulatory fallings.
ComplianceCompliance
30. • The adequacy of the firms internal control environment isThe adequacy of the firms internal control environment is
judged by the complexity of the managers investment strategy.judged by the complexity of the managers investment strategy.
• Managers who trade in complex OTC derivative instruments willManagers who trade in complex OTC derivative instruments will
need to ensure, for instance, that there are sufficient backneed to ensure, for instance, that there are sufficient back
office staff to chase up and review long form confirmations.office staff to chase up and review long form confirmations.
• Where the volumes are large straight through processing is toWhere the volumes are large straight through processing is to
be used while accounting for the transaction to minimize thebe used while accounting for the transaction to minimize the
manual intervention.manual intervention.
• Segregation of duties are to be made between the interrelatedSegregation of duties are to be made between the interrelated
functions.functions.
• Wire transfers and other asset movements must be tightlyWire transfers and other asset movements must be tightly
controlled.controlled.
• No manager should allow assets to be moved outside the fundNo manager should allow assets to be moved outside the fund
on a single signature and there should be effective segregationon a single signature and there should be effective segregation
of duties over cash movementsof duties over cash movements..
Internal Controls and ProceduresInternal Controls and Procedures
31. • Regulators in US and UK markets increasing their attention onRegulators in US and UK markets increasing their attention on
industry pricing practices and seeking more independence ofindustry pricing practices and seeking more independence of
valuation.valuation.
• There is risk of using asset valuations to artificially boost theThere is risk of using asset valuations to artificially boost the
funds performance or to smooth “mark to market” losses.funds performance or to smooth “mark to market” losses.
• The presence and choice of a third party fund administrator andThe presence and choice of a third party fund administrator and
auditors will be indicative of the independence of valuations.auditors will be indicative of the independence of valuations.
• If the investment strategy trades in thinly traded or illiquidIf the investment strategy trades in thinly traded or illiquid
instruments there is inherent valuation risk involved.instruments there is inherent valuation risk involved.
• Investors can reduce valuation risk resulting from poorInvestors can reduce valuation risk resulting from poor
operational controls and procedures surrounding the pricingoperational controls and procedures surrounding the pricing
process, by ensuring that the fund is following three best practiceprocess, by ensuring that the fund is following three best practice
principles:principles:
• ValuationValuation transparencytransparency
• ConsistencyConsistency
• Independent oversightIndependent oversight..
Portfolio PricingPortfolio Pricing
32. Extent to which the investment manager clearly communicatesExtent to which the investment manager clearly communicates
to investors the specific methods and processes used to valueto investors the specific methods and processes used to value
securities when determining the NAV for dealing purposessecurities when determining the NAV for dealing purposes
Develop a comprehensive, writtenDevelop a comprehensive, written “Pricing Matrix”“Pricing Matrix” whichwhich
describes in detail the specific methods used to value each typedescribes in detail the specific methods used to value each type
of instrument.of instrument.
This pricing policy should be maintained by the third-partyThis pricing policy should be maintained by the third-party
administrator and can normally be made available to investorsadministrator and can normally be made available to investors
at the direction of the manager.at the direction of the manager.
Use of a valuation committee for formal documentation of theUse of a valuation committee for formal documentation of the
valuation exception which will minute changes to policy, pricingvaluation exception which will minute changes to policy, pricing
or exceptions that have been included in particular NAVs.or exceptions that have been included in particular NAVs.
Valuation TransparencyValuation Transparency
33. • Similar securities to be valued the same way both at a point inSimilar securities to be valued the same way both at a point in
time and over time.time and over time.
• Equally, if multiple quotes are available, they should beEqually, if multiple quotes are available, they should be
averaged in the same way, across all funds managed by theaveraged in the same way, across all funds managed by the
firm, to ensure consistent sampling of market price dispersionfirm, to ensure consistent sampling of market price dispersion
month-to-month.month-to-month.
• Source of quotations shall not be “cherry picked” to select theSource of quotations shall not be “cherry picked” to select the
most favorable mark at each month end, (be it the highest mark,most favorable mark at each month end, (be it the highest mark,
or the sources which best smooth portfolio performance).or the sources which best smooth portfolio performance).
Price ConsistencyPrice Consistency
34. • Back office should oversee the month end pricing process, rather thanBack office should oversee the month end pricing process, rather than
front office personnelfront office personnel
• It ensures that managers do not mark their own books without backIt ensures that managers do not mark their own books without back
office verification.office verification.
• Appoint a leading independent third-party administrator who is taskedAppoint a leading independent third-party administrator who is tasked
with oversight over the month end valuation process.with oversight over the month end valuation process.
• Best practice calls for the administrator to calculate the monthly NAVBest practice calls for the administrator to calculate the monthly NAV
incorporating valuations which are derived exclusively from sourcesincorporating valuations which are derived exclusively from sources
independent of the manager.independent of the manager.
• Such sources includesSuch sources includes brokers, price vendors and third-party valuationbrokers, price vendors and third-party valuation
agents for complex OTC derivatives.agents for complex OTC derivatives.
An Independent valuation processAn Independent valuation process
35. • Funds should always be independently audited, preferably by aFunds should always be independently audited, preferably by a
“big four” or specialist audit firm with a market reputation for“big four” or specialist audit firm with a market reputation for
auditing hedge funds.auditing hedge funds.
• All prime brokers and other counterparties should be high qualityAll prime brokers and other counterparties should be high quality
financial institutions and there should be transparency in thefinancial institutions and there should be transparency in the
identities of counterparties that are chosen by the manager.identities of counterparties that are chosen by the manager.
• The independent third-party administrator plays an extremelyThe independent third-party administrator plays an extremely
important role to protect investor assets by calculating the netimportant role to protect investor assets by calculating the net
asset value of the fund, independent of the manager.asset value of the fund, independent of the manager.
• Note that not all administration work is created equal andNote that not all administration work is created equal and
anything less than full service fund administration (i.e.anything less than full service fund administration (i.e.
preparation of a complete set of accounting records) increasespreparation of a complete set of accounting records) increases
operational risk for investors.operational risk for investors.
• Investors in these funds must consider the manager’s reasonsInvestors in these funds must consider the manager’s reasons
and what compensating controls, if any, are present ifand what compensating controls, if any, are present if
independent oversight over the trading NAV is absent.independent oversight over the trading NAV is absent.
Quality of Service ProvidersQuality of Service Providers
36. ConclusionConclusion
Operational risk in hedge funds is a potential “time bomb” forOperational risk in hedge funds is a potential “time bomb” for
investors. Investors must increase their focus on this aspectinvestors. Investors must increase their focus on this aspect
of their investments and not wait for either the regulators or aof their investments and not wait for either the regulators or a
disaster to alert them to these risks. Hedge fund investors,disaster to alert them to these risks. Hedge fund investors,
while primarily focused on their headline risk, should alsowhile primarily focused on their headline risk, should also
keep in mind that good operational due diligence will helpkeep in mind that good operational due diligence will help
them avoid funds which may suffer a drag on performancethem avoid funds which may suffer a drag on performance
due to weak controls, frequent errors or poor internaldue to weak controls, frequent errors or poor internal
information. Overall, investors who consider operationalinformation. Overall, investors who consider operational
factors will make better informed investment decisions andfactors will make better informed investment decisions and
receive more secure returns. Chief Investment Officers,receive more secure returns. Chief Investment Officers,
Investment Committees and ultimately Boards of Directors willInvestment Committees and ultimately Boards of Directors will
take comfort that sufficient attention has been given to thetake comfort that sufficient attention has been given to the
operational as well as investment issues within the portfoliosoperational as well as investment issues within the portfolios
under their charge.under their charge.
