Virginia Reynolds Parker examines the management of risk in FoHFs and outlines a range of issues central to the concerns of managers and investors.
Together with many others, these issues are highlighted and addressed in the recent book 'Managing Hedge Fund Risk - Strategies and Insights for Investors, Counterparties, Hedge Funds and Regulators', edited by Ms Parker and featuring articles by a number of hedge fund experts.
Virginia Reynolds Parker is the founder of Parker Global Strategies (PGS), a firm that specialises in custom designing and managing funds of hedge funds (FoHF) for institutional clients across the globe. Since 1995, PGS has designed over 20 multi-manager programmes and advised on over USD1.75 billion. PGS was among the first FoHF firms to apply risk management oversight to its funds.
HW: How far has risk management evolved within the hedge fund industry?
VP: Risk management has developed considerably further for hedge funds than for funds of hedge funds. Most hedge funds to which sophisticated hedge fund investors would consider allocating have well devised risk management practices and often a separate person or team responsible for risk assessment.
Sophisticated risk management techniques have been much slower to infiltrate funds of hedge funds. There are certainly some that follow "best practices" but most are still fairly naïve in their risk measuring, monitoring, and management.
HW: What is the role of the FoHF manager with regards to risk management?
VP: Unless a FoHF manager has a separate account, the FoHF manager cannot control or influence those actions of the underlying hedge fund manager. That being said, assuming all investments in third party funds, a FoHF manager can still develop a framework for risk measurement, monitoring, and management that will work within the constraints of the form of investment.
For example, the FoHF manager should require a minimum amount of transparency from each hedge fund manager, which may vary according to strategy, length of record, and sensitivity of information. All hedge fund managers should be willing to provide a level of information that is helpful to the allocator in assessing the level of risk being taken, potential style drift, concentration of risk, and liquidity measures. A FoHF manager should use diversification as the first line of defense in risk management - across managers, styles, and geographical regions.
Where possible, the FoHF managers should use quantitative measures and periodic reviews of risk reports to monitor style consistency and performance relative to peer groups. As so much capital chases hedge funds, the FoHF manager should also monitor capacity issues carefully, on a manager-by-manager basis. The largest and best know managers are often not the strongest performing, even when they once were at a smaller size.
HW: What is the biggest risk of investing in hedge funds?
VP: The biggest risk of investing in hedge funds is underperformance. Hedge funds are cyclical, because many of the opportunities for a particular strategy are influenced economic and market factors. Additionally, a particular hedge fund manager may have an "off" year, while still retaining its skill and ability for future returns.
And, of course there is always the possibility of a disastrous drawdown, but fortunately these are not terribly common. That being said, one should always expect over time that a hedge fund manager's maximum drawdown will at least equal, if not exceed, their annualized standard deviation. Fraud is probably the smallest and least common risk in hedge funds. There are some well-known incidents, but most often fraud has been committed by small, obscure firms.
HW: Are there any 'best practice' rules for FoHFs in respect of risk management?
VP: Effective risk management begins with strong, upfront due diligence, long before the initial investment is made. The FoHF manager should attempt to identify each operational and market risk, and develop a level of comfort that the hedge fund manager understands each of these risks and has devised methods of addressing them.
The FoHF manager must determine which risks and level of risks are acceptable and which are not. We find that much of the market now follows "check the box" due diligence which often predefines certain risks, which may not be a risk at all, and misses others. For example, as small level of AUMs for a hedge fund manager is not necessarily bad, so long as the manager is in liquid strategies and has sufficient capital to maintain its business.
Large hedge fund managers are often content collecting management fees and are less concerned about achieving high performance. Once a hedge fund has been selected, a team must continue to perform due diligence, monitoring the manager, the organization, the performance, the portfolio, and the strategy and market environment for the strategy.
Many very large FoHFs, burdened by huge capital and significant inflows, have been slower to redeem for underperformance or when structural changes have called into question the ongoing feasibility of a strategy, like convertible arbitrage during 2004 and 2005.
HW: How can institutional investors exercise better risk controls over their hedge fund investments?
VP: Often the ability to redeem is the only remedy to addressing unacceptable risk because, unless an investor has a managed account, they cannot influence or control the investment. In some cases large investors who are very concerned about controlling risk may want to explore managed accounts.
The issue with relying on managed accounts exclusively is negative selection. The reduction in risk is almost always at the expenses of return. The best defense is diversification. A multi-manager portfolio of hedge funds should include at least 15 to 20 funds (unless the FoHF or multi-manager program is focused upon a single market sector). Investors should avoid funds with a lock-up of more than one year, unless the underlying strategy's liquidity really requires such a lock-up.
There has been a tendency for hedge funds to increase lock-up provisions, even when they haven't changed their strategy. Also, investors should understand that there is a great cost to redeeming from a hedge fund that has early redemption penalty. One percent is reasonable, but many funds are now charging from 2% to 6% for early redemptions. The costs can become quite high for changing managers.
HW: What should FoHF managers do to facilitate risk management by institutional investors?
VP: FoHF managers should share their risk management techniques and be very opened and transparent with their investors.
HW: What are the pros and cons of the various risk measurement systems now available to investors?
VP: Most risk measurement systems are designed for hedge funds, not for FoHFs. Most systems are significantly more laborious to run than vendors would suggest. Finally, it is very easy to get garbage out of a good system, because the inputs were flawed. On the positive side, risk systems have become somewhat commoditized.
More people understand FoHF risks and issues and are better with inputs. Assuming appropriate inputs, a quantitative, factor based system can be a powerful tool (which must be used with other quantitative and qualitative tools) to assess FoHF risks.
HW: What is stress testing and how useful is it?
VP: Stress testing is useful, but one must decide why it is being used. Does done want to limit the potential fat tail risk, which suggests potentially giving up targeted returns? Or does one simply want to see the potential size of a loss.
Perhaps stress testing is most interesting when building a portfolio of managers and strategies, or examining the effect of adjusting allocations, adding, or redeeming from certain strategies or hedge fund managers in a FoHF portfolio.
HW: What are the benefits of leverage and sector analysis?
VP: Leverage is probably the least useful tool for assessing risk, because leverage has a very different meaning and risk across various strategies. Sector analysis is useful for understanding sector bets and concentrations of risk.
HW: What is the most effective method of measuring performance?
VP: Performance should be considered from both an absolute and risk-adjusted perspective basis. For risk-adjusted performance, the allocator should consider the "quality" of the earnings - including exposure to market value, diversified or concentrated portfolio, liquid or illiquid portfolio, conventional or esoteric strategy, long or short optionality, independent or conflicted pricing, strong or weak price discovery, small or large market impact (when buying or selling positions).
HW: Finally, what, in your experience, is the best overall method of managing risk in funds of hedge funds?
VP: Nothing beats strong, upfront due diligence by a knowledgeable and experienced team of allocators.