Sources of Risk

The name “hedge funds” seems to imply risk reduction (since “hedging” is a risk reduction technique), but this need not be the case. It is better to think of a hedge fund as a fund that hedges away any risk not related to its speculative strategy. The riskiness of a hedge fund therefore depends intimately upon its strategy. This contrasts with a traditional active fund where most of the risk comes from the benchmark, and a minority from the active portfolio strategy.

For traditional active funds, risk is measured in units of total return or in units of active return. Active return equals total return minus benchmark return. The performance of traditional fund managers is measured in terms of their active return against the benchmark, so active risk is the primary concern of the portfolio manager.

The fund’s investors care both about total return (in order to measure the overall risk of their investment) and about active return (to ensure that the portfolio manager is properly positioned in terms of the investor’s allocation of funds across benchmark types). For hedge funds, active risk management and total risk measurement are equivalent since the benchmark is risk-free cash.

Using our theoretical definition of a hedge fund as the “purely active” component of a traditional fund, total risk measurement of a hedge fund is theoretically equivalent to active risk measurement of a traditional active fund. To summarise, for a hedge fund, total risk measurement and active risk measurement are the same, and they are theoretically equivalent to active risk measurement of a traditional active fund.

As mentioned above, hedge fund risk exposure is strongly dependent on the investment strategy chosen. In a well-run hedge fund, the only risks remaining in the portfolio are those that are intimately connected to the fund’s speculative strategy, or those that it is impossible or too costly to hedge away. The market risk of a global macro fund includes the movements of currency exchange rates, interest rates, commodity prices, and equity prices. Tactical trading and long-short equity funds are affected by specific equity price risk.

Hedging generally reduces correlation with a broad market index, but the equity trading strategy may increase correlation with changes in particular industry sectors or global regions. Fixed-income arbitrage is directly affected by market risk (the yield and duration of debt securities) and often by credit risk, materialised in the creditworthiness of the debtor companies. Of course, CTAs are affected by commodity risk.

Some hedge funds incur liquidity risk, such as those specialising in emerging market equities or distressed assets, which target illiquid securities that may be overlooked and mispriced by other analysts. Often, the profitable trading strategies of arbitrage-based hedge fund strategies include active positions in securities with limited or uncertain liquidity. Hence liquidity risk is of particular importance in risk measurement for hedge funds.

Hedge funds have two sources for credit risk. A hedge fund that specialises in distressed securities or fixed-income arbitrage is exposed to the default risk of debt securities that it owns. More significantly, most hedge funds use leverage, which subjects them to the other type of credit risk, the need to repay the financial institutions that extend hedge funds their credit.

Under extremely adverse market conditions, a hedge fund may face both credit and liquidity crises simultaneously. In an emergency (such as margin calls), the hedge fund may not be able to obtain additional credit and may be forced to obtain cash quickly. Other hedge funds, and similarly positioned traders, may be facing similar circumstances. A large imbalance between willing buyers and desperate sellers needing cash may compel a hedge fund to sell its portfolio below “fair value”. If many aggressive high-margin speculators have similar positions in a credit crisis, this can induce a liquidity crisis, or vice-versa. This type of interaction seems to have contributed to the collapse of LTCM.

These two types of investors possess a certain extend of financial knowledge and a willingness to bear the risk a HF investment carries. The investor’s risks are.

• Liquidity risk: Limited ability to withdraw money at short notice, given that lengthy lock-up periods or other redemption constraints are in place.
• Valuation risk: Although generally valuation of HF assets is outsourced to administrators or prime brokers, the manager retains the final right to modify asset values and HF performance may be misrepresented.
• Human risk: The success of a HF depends on key people managing it; the departure of certain managers may therefore adversely affect future performance.
• Style drift risk: The risk that the manager may change or abandon the stated primary strategy or strategies without informing investors; the future risk-return profile, correlation with other asset classes may no longer suit the investor portfolio.
• Size risk: Some strategies may no longer be viable when assets under management exceed a certain threshold.

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