Few private investors will have managed to escape from the words "risk management" in the process of making their investment decisions. Often used rather glibly, the concept of risk management should be the first thing that potential investors familiarise themselves with.


Craig Reeves is Managing Director of Platinum Capital Management, which invests money with alternative based hedge fund managers (those working the hedge or derivative fund arenas) and then offers access to those managers through the various Platinum funds of hedge funds.


In this article, Reeves explains some of the tools that Platinum uses in choosing advisors and then in practising risk management having chosen them. "The objective of the exercise is to be able to obtain high risk adjusted rates of return," he says. In other words, the simple aim for investors is to make as much money as possible with as little risk of losing that money in the process as possible.


Risk Measurement


The first step to achieving the risk management is in measuring risk. Here a number of academics have worked out various theories on risk measurement. The most familiar is the modern portfolio theory, which measures the uncertainty of the expected return by the volatility of the standard deviation over time.


Standard deviation is technically defined as the square root of the average of the squared deviations of monthly rates of return from the arithmetic mean rate of return. The lower the number, the better it is if you want low volatility.


However, this equation means that both the ups and downs are factored in, so the figures are distorted. The post-modern portfolio theory academics came up with is semi-deviation, which measures only the downside risk which looks only for the observations that fall below the mean. Platinum classifies upside vol as "in your pocket volatility" and downside vol as "back to market volatility".


Another way of looking at the risk is to look at the history of loss of a particular fund or equity. In the hedge fund arena, losses are known as "drawdowns" and are specifically designed as the worst highest peak to lowest valley loss. Platinum also looks at individual managers and at over what period the drawdown has continued or "For how long you are under water".


These are just some of the key ways to measure risk and they can all help with putting together an investment strategy. The next stage of Platinum's work in choosing fund managers is, according to Reeves, to draw up a square matrix, divided into two columns with Pro-active at the top of one, and Real Time under the other. Then on the horizontal, divide the square into quantitative and qualitative. You must pay equal attention to all four.


The first area that Platinum Capital Management looks at in the matrix is Qualitative/Pro-Active. This is the normal due diligence testing that any investor should do before putting his money into the fund. Is the fund registered?, does it have a regular audit?, and so on, combined with less pragmatic concerns such as does the manager have a vision?


The next square is the Quantitative/Pro-Active Square and here is the testing with capital or back testing or applying independent audits. Clearly, a professional firm, such as Platinum, examining the work of new managers, more easily undertakes these steps but the theory can be useful for private investors.


Next comes Real Time/Quantitative, which is the ongoing portfolio-monitoring phase with operational risk management and stop-loss dynamic asset allocation. Finally, Platinum Capital Management looks at the real Time/Qualitative part of the matrix. Here there is an on going evaluation whether the manager, his strategy and the market still fits Platinum's overall investment aims.


Risk Management Strategy


A lot of banks and people believe that if you watch your positions closely- that's risk management, but an investor, whether professional or private, must set a risk management strategy from the outset.


Another form of risk management present within many funds is a stop/loss policy, which dictates that should certain positions be reached-, say minus 5 percent from the high water mark - the manager will cancel all positions. This can be a great comfort for the investor but it can limit that manager in his investment activity, making it difficult for him to achieve performance over the long term.


Talking Derivatives


Derivatives are still widely associated with bank collapses, scandals and dirty dealings, however in reality derivatives are simply derived from underlying assets- whether you actually invest in the physical stuff or the future is irrelevant- you still have the exposure.


The factor that can make direct investment in derivatives dangerous for the inexperienced investor is the fact that derivatives are leveraged or have gearing. Futures and options are traded on margin. When you buy a future, you pay around 5 per cent of the total contract value with variation margin payable on a daily basis. This means that GBP 5 per ton initial margin for one ton of wheat futures at GBP 110 can turn into a substantially bigger gain or loss if the market in wheat moves drastically.


That GBP 5 could become a loss of GBP 10 for every ton if the price fell to GBP 100 per ton and it would show a profit of GBP 45 per ton if the price rose to GBP 160.


From this example, it is easy to see how a bank's fortune could be lost, with very little actual capital at play. Leverage is a very potent tool and should be applied with caution or care-however, it can help reduce risk. By using leverage and its lower transaction costs, the investor can get efficient access to a well diversified portfolio.


Leverage is like a turbo in a car - it can be used to get there safely and overtake quickly and efficiently but you shouldn't use it in a city and you must be a skilful driver.


If you don't feel that you can be a skilful driver with derivates investment, then the most sensible route may be to go into a derivatives fund. Here you will have professional fund managers choosing trading managers using many of the above criteria, and then overseeing those managers.


Investor Protection


You will also have the comfort of a regulated fund structure and all the investor protection that brings. Whatever markets we are in, whether bonds, equities, fixed income or commodities, we want the best systematic and methodical managers.


The concept of using diversification to lower risk is one that Platinum offers through its range of offshore investment funds. By combining assets with low or negative correlation, it is possible to maintain the same expected return, while decreasing the risk.


The theory is that as the correlation between the returns for assets that are combined in a portfolio decreases, so does the risk of that portfolio. However, few assets have small to negative correlation to other assets. Research has shown that stocks and bonds, for instance, are typically very correlated.


Platinum Equity Plus Fund


Platinum achieves non-correlation by using asset class and segment specific strategies, with different managers using distinctly different strategies. The Platinum Equity Plus Fund comprises 6 different strategies and multiple-asset classes and instruments giving rise to the highest potential reward / risk. Platinum takes all these specialities and combines them to get enormous diversification and zero-correlation in our multi-manager fund, Platinum Equity Plus Fund, and having done that, then you get the magic of diversification.


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