Mercer study reveals strengthened global hedge funds industry risk management practices and highlights areas for improvement

Hedge funds and their broker dealers have strengthened the quality and scope of risk management compared to historical practices, according to a new study.

According to a new study of the global hedge fund industry conducted by Mercer Oliver Wyman, the global financial services strategy and risk management consultancy, the global hedge funds industry has made significant resource, system and organizational investments to manage risk. The improvements made to the risk infrastructure are aimed directly at working to reduce the likelihood of a fund failure and to limit the impact any such failure might have on their investors, the larger broker dealer community and global financial markets as a whole. However, all the participants in the study recognize the need to continuously address the challenges of increasingly sophisticated and differentiated risks produced by the growing and evolving industry.

The study finds that the largest institutions have worked together to effectively better understand and improve the management of the traditional risks faced by the industry in the areas of liquidity, market, credit, legal, and operational risk. The industry as a whole has taken steps towards codifying and standardizing procedures to manage the execution, processing and documenting of trades, as well as increased efforts at independent trade validation practices, all of which will broadly contribute to the safety and soundness of the financial system.

'The leaders in the hedge fund industry and their banks have made substantive strides in many dimensions of their risk management practices,' said Bradley Ziff, Director in the Finance & Risk and Capital Markets practice at Mercer Oliver Wyman. 'The largest, most influential hedge funds and their creditor banks have an extremely sophisticated understanding of their risk profiles and the market and have strengthened their ability to manage through a potential crisis.'

Study participants noted that there was still work to do in a variety of areas including: independent pricing and valuation of illiquid securities; strengthening their ability to identify market correlations and their impact; greater use of electronic platforms to increase operational efficiencies; and standardizing industry documentation to reduce potential problems that would arise from termination events or similar market disputes.

The nearly USD 1.5 trillion dollar industry continues to come under scrutiny because of the on-going flow of investment capital; the importance of the hedge fund clients to banks; and the critical impact hedge funds can have through their trading across asset classes in both developed and underdeveloped financial markets. The focus on hedge funds has risen significantly since the re-capitalization of Long Term Capital Management in l998 and other periodic events in the equity, debt and credit markets since that time.

Over the past decade hedge funds have developed increasingly complex and diverse investment strategies. Funds also seek innovative approaches to package their risks through a variety of structured transactions including a focus on corporate finance and aspects of investment banking. In response, the global investment banks have provided an expanded set of products and services. Together, these developments have created new sets of risks which demand an on-going evolution of risk management across the industry. However, the study notes that industry risk management practices have been challenged to keep pace with the speed of product and market change leading to significant consequences and that bridging this gap continues to be the highest priority of market participants.

'The results of this study should be kept in perspective. Hedge funds, their investors, their creditors and now regulatory bodies, face a continuing challenge to keep up with the dynamic and evolving approaches to taking and managing risk,' Ziff commented. 'Significant achievements have occurred. But this has not happened overnight, rather through a steady and focused effort by industry participants in both the public and private sector. However, the industry recognizes that substantially more needs to be done and continued prudence and diligence going forward will be necessary to keep pace with market innovations.'

Collectively, the improvements in risk management practices among the most sophisticated hedge funds and their broker-dealers should serve to increase the stability of global markets in times of volatility. The hedge funds included in the study have structured themselves to optimize their long-term liquidity and have improved their understanding of market and liquidity risk management, increasing their ability to manage the effects of shocks due to various market disruptions. Enhanced use of stress-testing should assist their management of risks in diverse portfolios that might be correlated across markets.

For the study, Mercer Oliver Wyman interviewed more than 100 risk professionals and fund managers at 15 global broker dealers and 35 top hedge funds. The study is the first market review since guidance on risk management was issued by the Federal Reserve, the Securities and Exchange Commission, the Financial Services Authority, and the Counterparty Risk Management Policy Group (CRMPG) last year.

The dealers studied account for over 90% of global business banks do with hedge funds. The hedge funds studied were among the largest and most established funds. The findings of the study illustrate the risk management practices common to the most sophisticated institutions that have the most significant influence on markets.

Study Highlights:
 
Liquidity and credit risk management
Liquidity is a critical risk for both hedge funds and broker dealers. Hedge funds have developed the controls necessary to preserve liquidity; instilling longer lock-ups of 'capital' from both investors and dealers, along with gates and notice periods that should assist the funds' ability to weather short-term market events. Broker dealer institutions have, through transparency enhancements, improved their ability to review the liquidity status of the funds they serve and use scenario modelling to better understand those risks.

'Even the best hedge funds are exposed to the threat of market events that shock the system,' noted Mercer's Ziff. 'The need to model around these threats is critical to help identify and manage any singular event that could pressure a large, sophisticated fund into liquidating positions in an unplanned or untimely manner.'

The study found that hedge funds and broker-dealers make extensive use of sophisticated stress-tests and scenario planning. Today's systems evaluate a greater number of asset classes and can run more frequent analysis than ever before. However, the industry broadly shares the view that there is no quantitative methodology sufficient to identify crowded trades that could stress the system; scenario and stress testing can only aid the process.

As the hedge fund market becomes ever more institutionally oriented, market participants such as institutional investors and credit officers at broker-dealer and prime broker counterparts continue to work with funds to improve upon the transparency and disclosure of their risk taking activities. Many funds have made improvements in their risk reporting by standardizing of their risk data and investing in the infrastructure that support their business, for example; duplicating fund administrators' functions; establishing independent internal audit functions; and similar investments.

'As hedge funds continue to seek the larger business opportunity of the institutional market, we expect more transparency and disclosure of risk-taking activity. This, in turn, enables better risk management by the funds and dealers,' predicts Ziff.

In a departure from past practices, many hedge fund managers tend to share very similar risk data to both their investors and counterparty credit risk officers. However, risk reports still vary significantly among the top tier funds and there is limited consensus on what is appropriate and necessary information to provide their creditors and investors.

Almost all the funds queried reported that they will review on a monthly basis information related to their NAV, performance, some asset and position concentration data relating to particular risk factors, 'greeks' (such as beta, gamma, vega and delta risk), and/or results from stress-tests and scenario analyses, aggregate VaR or similar measurements.

Many hedge fund managers have designated personnel to manage compliance-related activities and continue to believe they are prepared to support regulatory changes, including potentially greater reporting requirements:

  • 100% of the dealers surveyed had dedicated credit personnel with an average of 18 analysts on the team
  • 93% of dealers report a high level of involvement from senior management in hedge fund transactions
  • Reputational risk concerning dealing with hedge funds is a significant concern to most dealers
  • 75% of dealers review their hedge fund clients' margin terms on a monthly basis with 60 or 90 day lock ups offered to select clients and 73% of hedge funds report using margin locks to strengthen liquidity management
  • 87% of dealers are actively negotiating credit terms to increase transparency and disclosure

Market risk
Due to the challenges of today's markets, dealers and funds have begun to aggregate risks to identify concentrated and correlated exposures. The study found that dealers are investing in a broad range of metrics to quantify and set limits of risk to individual funds and fund families. Almost every fund in the study performs risk aggregation and limit-setting at the position-, portfolio- and fund level. Risk managers and funds actively look for concentrations in particular risk factors across various portfolios, which might go unnoticed in isolation:

  • 77% of dealers have made significant investments to manage market risk in the past 24 months
  • 80% of dealers are currently investing in stress testing, risk modeling and scenario testing to better monitor and manage their exposures to hedge funds

Operational and legal risk
The industry is cooperating in becoming more standardized in its operations, reducing risk associated with documentation, legal, and confirmation of trades. The study found that funds and dealers are committing more resources and have enhanced the quality of their systems in order to give this greater attention and respond to the recommendations of the CRMPG. It is widely agreed that reducing operational risks should help dealers and funds limit potential systemic market impact.

At the same time, broker-dealers are investing heavily in their infrastructure to manage their business with hedge funds. Operationally, dealers have employed larger documentation teams, hired more specialized personnel to support their credit and trading operations for hedge funds, have stronger collateral management practices, and standardized reporting.

Additionally improvements in technology are helping the industry cope with risk. Significant advances at the Depository Trust & Clearing Corporation (DTCC) and the use of Swapswire have helped the industry attain greater operational efficiency. The funds surveyed were also found to be large users of third party risk systems and software to assist with valuation and validation of their risk measurement practices.

  • The vast majority of dealers have adopted straight thru processing and DTCC tracking to manage trade confirms
  • 100% of dealers have dedicated legal teams to deal with hedge funds with an average of 11people while hedge funds have an average of three attorneys on staff and95% utilize external counsel to aid in negotiation of trading terms and documentation
  • 67% of dealers use external platforms to track documentation and 75% of funds feel the use of these platforms has significantly reduced the risk of outstanding confirmations
  • 78% of the firms have developed specialized reporting packages on their hedge fund activities for senior management.
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