The widespread interest in hedge fund investing can be attributed to the attractive risk-reward characteristics of alternative investment strategies (AIS) and their low correlation with traditional asset classes. But a recent increase in investor concerns – expressed for example in a recent survey of institutional investors by the Barra consulting group – indicate that for AIS to achieve its full growth potential, the industry must address concerns about the diverse and partly unknown risks of AIS. Also at issue are the lack of investment transparency, low liquidity and long redemption periods that are still characteristic of hedge fund and managed futures investments.
For years, investors followed a ‘black box’ approach to AIS investing and accepted unregulated ‘Cayman Island Limited Partnerships’ with long redemption periods. A number of factors are now leading to a shift away from this type of approach. Increased interest from institutional investors in AIS has led to new demands for disclosure, better defined risk profiles and higher liquidity because of the fiduciary responsibilities associated with investing clients’ money. Several widely publicised hedge fund failures, such as that of LTCM, and periodic reports of other hedge fund ‘blow ups’ and fraud (for example, ‘Manhattan Fund’) have added to the concerns of all AIS investors. Finally, rapid developments in the financial industry in the area of financial risk management have made risk analysis for even complex AIS portfolios feasible on almost a real-time basis, and therefore have increased expectations with respect to the management of risk.
As a result, the AIS industry is going through an institutionalisation process, where hedge fund and managed futures managers are faced with demands for increased investment transparency, higher liquidity (shorter redemption periods) and greater clarity in terms of portfolio composition, strategy details, performance and fee attributions, and leverage. The trend in investors’ attitude from accepting (‘trust me’) to requesting (‘show me’) is clearly observable.
The issues of transparency and liquidity are among the most discussed subjects in the hedge fund industry. If one considers the monitoring of investment activities inside financial institutions like banks, broker dealers, corporate finance departments of large firms, insurance companies, endowments, pension funds and foundations, it seems difficult to imagine that external managers would be allowed to pursue completely unmonitored, and largely unregulated investment activities. To make matters worse, these strategies are exposed to a much larger variety of risk factors and can be made riskier at the discretion of the manager.
It should be clear that transparency is the fundamental and necessary condition for appropriate risk management for the AIS allocator (‘fund of funds’). Without transparency and the appropriate knowledge of the strategy, the control and management of risk is simply not possible and remains largely a guessing game. In contrast, transparency:
q provides the possibility of detecting previously unknown (or unrecognised) risks in the investment strategy;
q enables the AIS allocator to recognise undesired style drifts and singular ‘bets’ early enough;
q allows leverage to be controlled;
q enables the investor to examine all agreements the hedge fund is a party to, such as prime brokerage agreement, fee agreements, past audit reports, corporate registration, and others;
q significantly decreases the probability of fraud; and
q provides support for the challenging task of performance measurement (for example, accounting for the liquidity of open positions).
This, of course, is by no means a pledge to provide every single investor and the wide investing public access to confidential information about a hedge fund manager’s trading activities. There is a legitimate right for the hedge fund manager not to have his position be widely known. But hedge fund managers can set up confidentiality and non-disclosure agreements with the fund of fund managers.
I strongly disagree with the widespread view that AIS risk can be adequately monitored without obtaining the underlying positions. If risk and exposure monitoring without disclosure of positions were sufficient, the industry would likely see ‘best practices’ by the prime brokers as providers of leverage and financing for hedge funds (the other party besides the investor exposed to hedge fund counterparty risks). The prime brokers would monitor their exposures to hedge funds based on ‘aggregated risk information’ without bothering with the tedious job of identifying single positions. But in reality, prime brokers have full transparency of positions on a continuous basis, and so should the sophisticated investor. A high level of transparency provides the very foundation for effective risk management.
The belief that the best managers are necessarily non-transparent and AIS portfolio managers focusing on transparency are therefore left with ‘second-tier’ managers finds no empirical support. It is incorrect to link attractive returns with lack of transparency. Many high quality managers with excellent past track records are willing to offer the desired transparency, if asked or required (for an investment) to do so (it is increasingly considered a sign of quality, if a manager offers transparency with respect to his investment approach and trading activities). But, inversely, managers who refuse to provide transparency of their investment activities have a systematic disadvantage. Lack of transparency means a significant higher risk to the investor which according to capital market theory subsequently requires a higher return. But where should that return come from? It is not plausible that performance should depend on the fact that a fund of fund manager receives disclosure of the manager’s activities. Finally, the more openly a manager discloses his strategy, the more likely it is that he is able to present a clear edge.
The incorrect belief that the best performing managers must operate in secret is linked to persistent misperceptions about AIS. Many investors believe that AIS returns are mostly generated through the identification of unrecognised ‘inefficiencies’. The reality of AIS investing is that most strategies systematically earn risk premiums (see above). Most managers follow certain investment strategies that, not surprisingly, perform better in certain market environments than in others, and which bear a range of risks. With some effort most strategies are actually not too difficult to understand. Transparency is needed to allow for an adequate assessment of risks and returns.
Concerning the issue of liquidity, it has to be noted that hedge fund manager largely trade liquid and exchange traded instruments. Liquidity premiums do not form a large part of hedge fund returns (in contrast to private equity and real estate investments). The most effective way to address the need for both liquidity and transparency is via a managed account with the hedge fund manager. The hedge fund managers have special authority to execute trades on behalf of the multi-manager fund for accounts that are specifically set up for a manager’s trading strategy. Managed accounts provide the AIS allocator with full disclosure of the managers’ activities. The fund of funds manager can download the positions taken by each manager from the prime broker and monitor trading activities on a daily basis. The fund of funds manager is further in a position to select all involved parties and transaction counterparties including the prime broker, custodian, and auditor.
An important advantage of managed accounts from the perspective of the AIS allocator is the possibility of managing the cash portions in the hedge funds effectively. This itself can provide a certain level of liquidity. A ‘fund of managed account’ normally does not need to exercise on this high level of liquidity. He has the possibility to provide hedge fund investors with sufficient liquidity purely through the efficient management of cash. It has to be realised that there is always a certain amount of cash unutilized by the hedge fund managers in the execution of their strategy. In the right set-up, the hedge fund allocator can control this cash. Only in extreme market circumstances does he have to exercise on the liquidity granted through a managed account. But that is more then desirable. Why should the investor have to wait several months and wait until the room is empty when everybody else is rushing to the doors?
A note concerns the issue of regulation. There is increasing effort to establish a ‘hedge fund’ regulation scheme to be enforced by international monetary agencies. We believe that the increase in transparency and a willingness to disclose AIS positions to investors will diminish the urge for regulation. A flexible risk management and control structure established by the industry itself is surely more preferable than a rigid set of regulations.
The following are core elements of risk measurement in a multi-manager hedge fund portfolio:
q exposure analysis – the breakdown of the exposure to different aggregation levels;
q value at risk (VAR) – the most prominent measure of risk reflecting the ‘normal risks’ in the portfolio – Figure 1 presents an example of a VAR analysis in a hedge fund portfolio;
q stress tests and scenario analysis – extreme scenario analysis giving insight into the portfolio behaviour under extreme, but plausible, market conditions – Figure 2 presents an example of a stress test analysis in a hedge fund portfolio.
Risk measurement is an important element of risk management, but in itself it remains a passive activity. In contrast, risk management requires action and goes beyond risk measuring. Active risk management entails the dynamic and optimal allocation of risk among different assets and managers. It consists of defining and enforcing risk limits, performing dynamic portfolio allocation according to – possibly changing – risk parameters, and accepting certain risk factors, but eliminating others that are deemed unaccepted. Within a framework of active AIS active risk management, there are various ways to manage risk and exercise control over trading managers:
q regular conversations with managers about current and potential future risks;
q risk or exposure limits (‘risk budgets’) on different levels (global portfolio, single asset class, strategy sector, or manager) differentiating between risk levels and sources which are accepted, and those, which are not;
q imposing leverage controls and margin requirements;
q definition of stop-loss limits;
q request for explanations about unusual positions; and
q firing of managers with ‘issues’.
Risk management does not by itself lead to positive performance, nor does it prevent losses under all circumstances. But it helps to decrease the severity of losses. Risk monitoring and active risk management help to detect managers who are deviating from their strategies and thus prevent accidents and investment disasters. It should thus be an integral part of the AIS investment process. Performance generation is a matter of sector and manager allocation. For each strategy there exist hostile market environments that will lead to the strategy showing weak performance or losses. In a well-diversified AIS portfolio, lacklustre performance of single strategies should be balanced by above average performance of others for which market conditions are more favourable.
Lars Jaeger, author of the new book ‘Risk management for Alternative Investment Strategies’ published by Financial Times/Prentice Hall, is with Partners Group, in Zug, Switzerland