Managing Risk In Alternative Investment Strategies - Hedge Funds

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