Victor Wong finds investors are beginning to appreciate the potential scale of losses from quantitative hedge fund strategies

Not long ago, pension plans went through a difficult period of solvency shortfalls, when their investments suffered substantial losses and liabilities were inflated as a result of low interest rates. Many plan sponsors were forced to take a closer look at their benefit and investment strategies. In the midst of despair, they found an investment white knight, hedge funds, offering hopes of greater returns, lower risks and greater diversification at the cost of higher fees, stand-alone volatility, withdrawal penalties and illiquidity.

Due diligence is a key factor in protecting the interests of pension
plans' stakeholders through the design of an investment policy, the selection of investments and their managers and the allocation of assets. Plan sponsors were careful to allocate a small percentage of the assets to a diversified portfolio of alternative investments. Many have fallen into the illusion of the improved risk/return profile with the inclusion of alternative investments.

The recent fallout in the US housing market, worsening credit crunch and the slowdown in global economies have illustrated the reality of this crowded asset class - that it is mainly unproven and untested over time. To achieve outstanding returns, there will be a cost as investment managers need to place bets based on their judgment and sometimes through the use of excessive leverage. As Milton Friedman put it: "There ain't no such thing as a free lunch".

Many hedge funds illustrated their return/risk profile through historical simulation or actual but limited histories. Many of these funds make use of quantitative strategies or trading rules as their means of risk management. I would argue that such quantitative strategies or trading rules are forms of systematic risk as long as there is no creditable guarantor to insure against any losses.

The lack of performance histories gives investors an illusion of security. The market correlation was much different from expected. The extent of potential losses could be larger than anyone would admit. Unfortunately, the plan sponsors used such systematically flawed information as the basis for their investment decisions.

Investors have begun to realise the potential range of losses on these funds. In August, Goldman Sachs became a high-profile upset in quantitative hedge fund strategies. The effect was much more dramatic than anyone could have anticipated. Goldman's flagship Global Alpha fund, which uses quantitative strategies across a range of asset classes, lost close to 30% of its value.

In insurance terms, we call these extreme values ‘fat tails'- sustainable large losses with much higher than normal probabilities.

Sadly, few in the industry would come forward to illustrate such risks to existing or potential investors, as this would not be viewed as a competitive strength. However, this is the critical information needed by investors and plan sponsors alike to evaluate the level of risks in their investment decisions. Public rating agencies or investment consultants are unable to measure such risks, as the funds' trading activities and algorithms are well-guarded secrets.

It will be up to regulators to set standards in the measurement of performance and risks for a largely unregulated industry in order to provide more useful information to investors. Currently, it is up to individual institutional investors to demand quantitative measures of risk rather than relying simply on historical performance and reputation.

Traditionally, risk is measured as the volatility of returns over a certain time horizon. More recently, institutional investors have become more concerned about the magnitude and likelihood of downside risks.

The banking and insurance industries are now coming up with standards to measure financial institutions' risks in the form of risk-based capital. Advanced banking risk models require banks to determine the level of risk-based capital based on their internal risks and exposures through simulation and value at risk (VAR). VAR is defined as the maximum loss not exceeded with a given probability over a given period. It is commonly used by securities houses or investment banks to measure the market risk of their asset portfolios.

In fact, the hedge funds industry could benefit substantially from having a standardised risk measurement to improve its investment strategies, management and capital allocation. For many hedge funds, the key factor would be liquidity. At a time of distress, the value of a hedge fund's portfolio could deteriorate rapidly due to overexposure without hedging. Proper risk measurement can be a powerful tool for investment managers to evaluate if their risk/return trade-off is rewarding and if their trading strategies can work in a distressed environment.

In determining VAR for a particular investment fund, hundreds of thousands of possible paths are simulated on the underlying assets and yield curves which in turn affect the value of the portfolio over a time horizon. The time horizon is chosen to be the length of time required to liquidate holdings. Together with the funds' quantitative strategies and liquidation rules, the potential gains/losses over the time horizon can be computed. The results of the simulation can then be ranked by gains/losses over the time horizon and the VAR is determined to be the maximum loss at, say 99.9 percentile.

With VAR, investment managers can quantify the likelihood and the potential exposures as well as the effectiveness of their strategies in an uncertain market environment.

A more standardised risk measurement can give both plan sponsors and investment managers a whole new perspective in evaluating and comparing various investments and strategies. The current standards are ineffective and incapable of measuring the potential downside risks of hedge fund investments. In fact, the ‘fat tail' of this industry is still largely unknown.

With proper public awareness and initiatives, I hope that the industry will start incorporating proper risk measurement into its investment strategies and disclosures, enabling a healthy future development of this industry.

Victor Wong is managing director of Real Actuarial Consulting in Hong Kong