Hedge Funds And The New Risk Management Paradigm

Dec 5 2012 | 3:59pm ET

By Tyler Kim, CIO, MaplesFS -- As alternative investment strategies become significant and substantial parts of institutional investors’ portfolios, the risk management practices that they have traditionally employed are no longer adequate.  Generic, static risk measurement templates can create a false sense of comfort.   Supposed enhancements such as position-level transparency are often useless without methods for effectively distilling and utilizing such information. 

A flexible definition of risk has become essential in an era of unprecedented sophistication in investment strategies and enhanced governance practices.  Furthermore, the ability to not just measure risk, but foster ongoing risk awareness and dialogue with a broad audience—particularly including fund fiduciaries—should be the new objective.  This combination of customization and communication can result in an adaptive approach to risk management that enhances portfolio performance, and more importantly helps institutional investors to embrace alternative investments with greater confidence.

The New Paradigm

With fixed income yields at historic lows and equity markets exhibiting lackluster performance, more risk is required to generate the same returns achieved in prior market periods.  Institutional investors are compelled to look at alternative investments to expand their opportunity sets and enhance returns.  While the return profiles of such alternative strategies are attractive, they can also expose institutional investors to risks that they have not previously experienced. 

Meanwhile, the fiduciaries accountable for approving policies that permit these more aggressive strategies have become acutely aware of their responsibility to protect their beneficiaries’ assets from things like “bubbles” and “tail risk,” and are becoming increasingly interested in understanding and monitoring investment portfolio risks.  Fiduciaries are seeking ways to enhance the information that they are provided in order to ensure sufficient and effective oversight over the new, sophisticated strategies being proposed and employed.

Transcending Transparency

In addressing the need for better oversight, transparency is often touted as an improvement that will allow institutional investors to better manage risks. While transparency may be a helpful condition for enhancing risk management practices, it is hardly sufficient.  As a result of an emphasis on transparency, institutional investors often find themselves bombarded with a tremendous amount of information from managers, administrators, prime brokers, custodians and internal systems.  However, this data alone is of little value unless it is quality-checked, synthesized and interpreted to create specific and accurate insights that are utilized to enrich decisions about investment policies, allocations and manager selection.

Institutional investors must go beyond tactical risk management objectives such as transparency and focus on a goal that is more directly aligned to the end result they are seeking – insight into the right set of risk exposures that will allow them to make timely adjustments to their portfolios to optimize performance.  Achieving this goal will require changes to the way risk is defined and discussed by all parties concerned.

Customized Risk Definitions

Many traditional risk reporting solutions are based upon a set of metrics that are the output of formulaic calculations on standardized data sets.  Such consistent, periodic reports may make it easy to compare risk on a relative basis.  However, in an environment where every investor has different needs, strategies and exposures, relative indicators have lost some meaning.  A generic definition of risk could result in a failure to adequately capture the impact of a wide array of idiosyncratic risks manifested within alternative strategies that are, by definition, unique.

Furthermore, in an environment in which many risks are unknown, and unprecedented events frequently occur, a standardized approach to risk management could result in systemic exposure across wide sets of investors that have adopted harmonized perspectives.  Invalid assumptions made by investor masses in the not-so-distant past—whether it be the safety of investment-grade debt issued by diversified CDOs , the justification of dot-com valuations, or the effectiveness of portfolio insurance implemented through programmatic trading—should serve as reminders that a herd mentality coupled with new phenomena seldom ends well.

In a paradigm of more diverse investment strategies, there is no one way to appropriately define risk.  Risk starts with individual managers and the strategies they are employing.  It then rolls up to the investors that have created portfolios of managers’ strategies.  While it can require more thought, work and communication, a customized, bottom-up approach to establishing an appropriate risk framework is the only effective way to define risk in today’s environment. 

Risk Dialogue

A robust dialogue between all interested parties is required to establish this customized definition of risk.  Hedge fund managers must openly disclose and explain the specific risks associated with their investment strategies to institutional investors and their consultants.  They must demonstrate on a continual basis that they are not only monitoring the effectiveness of their strategies in terms of performance, but are also managing risks appropriately, and operating within the constraints of the investment management agreements in place to contain those risks.

The investment teams and their consultants can then develop a risk management framework that considers and consolidates information from each manager, creating a comprehensive “risk dashboard” that is uniquely tailored for their portfolio.  The institutional investors’ fiduciaries must be informed of these risks, in terms that they can appreciate; their provision of oversight can only be effective if they are aware of what they should be looking at.  This dashboard then becomes a recurring reference point for the managers, investment teams, consultants and board members to have on-going conversations to ensure that their investment decisions and portfolio positioning is aligned with the risks they are willing to take.

This regular risk dialogue can have a direct, positive impact on investment performance.  If risks are well understood by all parties concerned, obtaining the buy-in necessary to mobilize capital in response to new opportunities (and threats) becomes a much faster process.  In dynamic and unpredictable markets, increased dexterity and responsiveness create significant advantage.

Continual Adaptation

Just as static asset allocation models are not appropriate in dynamic market environments, neither is a static approach to risk management.  Investment strategies change in response to new opportunity sets.  Managers come and go.  The biases and risk appetites of institutional investors evolve.  Under such circumstances, even the most effective risk management framework cannot hold for long.  However, if the concepts of customized risk management and robust risk dialogue are adopted by all interested parties, continual adaptation should be a natural process.  Different risk measures can be introduced.  Tolerance thresholds can be adjusted.  New benchmarks and factors can be incorporated.  The risk framework itself, and not just the measures it produces, should be under constant scrutiny and evaluation.

With a philosophy of adaptive risk management successfully implemented, institutional investors will be better prepared to embrace the era of alternative investments.   Managers that help to foster the requisite conditions for adaptive risk management—through demonstrating the right disclosure, education and communication—will ultimately be serving their investors better, and contributing to everyone’s shared goal of engaging in innovative new investment opportunities, safely.  

Tyler Kim is the Chief Information Officer for MaplesFS, responsible for Information technology and data management functions globally across the fund services and fiduciary operations. He specializes in the development and integration of systems to support efficient middle- and back-office processes within the investment management industry and has extensive experience in hedge fund operations, derivatives trade processing and transfer agency services.


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