Hedge Funds: A Risk Manager's Viewpoint Frances Cowell, Director
R-Squared Risk Management, London
Asking the Right Questions
Regulators on both sides of the Atlantic are seeking to protect investors with new regulation to capture all investment products, including hedge funds and absolute return funds that have, until now, been largely unregulated. Whatever the outcome, it is up to investors to satisfy themselves that the risks taken by their managers are justified by the expected returns. The key is to ask the right questions.
There are good arguments both for and against regulation. Well thought-out controls can improve the information available to investors and, therefore, increase their confidence. Poorly contrived regulation merely increases management costs and raises the barrier-to-entry for new and potentially innovative products, which hurts investors by increasing costs and reducing the choices open to them. Ill-conceived controls can also impose a drag on performance by reducing the manager's scope to achieve the best return-to-risk balance and – worst of all – can even have the paradoxical effect of increasing the risk to investors by giving a false sense of security.
One of the priorities of regulators is to prevent a repeat of the catastrophic losses that caused so much damage in 2007 and 2008. But is this aim realistic? It is worth remembering that, while the sources of the meltdown are still being debated, few believe that it originated with hedge funds. Two possible culprits, banks – responding to very low interest rates – and the mortgage market were already well-regulated and supervised. Large banks ran daily stress tests and scenario analyses that failed, at the time, to tell them how vulnerable they actually were.
Nevertheless, the nominal size of hedge fund investments arguably warrants a closer look and the catastrophic losses incurred clearly point to widespread failure of risk management. Ultimately, whether regulators provide effective controls and supervision for this genre of fund or not, it is the responsibility of investors to see that the returns they get from their investments warrant the risks that are taken. Relying solely on regulators for your peace of mind is like relying solely on traffic signs when you drive your car: definitely better than nothing – providing the lights are functioning – but no substitute for looking where you are going. What, therefore, should you be looking for?
We are frequently reminded of the 'bewildering' range and complexity of hedge fund strategies. Whether you think they are bewildering or not, they are by no means uniform. Despite this diversity, due diligence and governance processes typically comprise a set of standard questions, many to do with risk measures. These processes are both necessary and valuable, and much of the data they gather add genuine insight into the risks of some funds. But risk measures that are not directly relevant can distract from the real issues. They also often belie a premise that the less risk there is, the better. Does this make sense?
Common sense tells you that attractive returns can be earned only by taking risks. Risk is what drives your return. In general, if you minimise risk, then you minimise your return, so it is odd to seek a blanket reduction in risk.
Recognising the inseparability of return and risk is the key to risk management: risk should be accepted only if it is expected to lead to extra return. If it is, it should be nurtured and managed. If it is not, then it should indeed be eliminated. The aim of risk measurement is to understand which is which. Failure to do so allows potentially lethal sources of risk to go unnoticed – and therefore unmanaged – leaving the fund vulnerable to catastrophic losses.
This is the question you should aim to answer. But few fund fact sheets or performance and risk reports volunteer this information in an easy-to-understand way. So you need to be clever to find out what you need to know. A few 'rules of thumb' can be helpful.
Risk management is not the same as risk minimisation. The objective is to manage risk, not necessarily reduce it.
Risk measurement should be comprehensive and include all risk that is ultimately borne by the investor; including gearing and counter-party risk, as well as market and factor risk, as these risks can, in turbulent markets, compound each other. This is important, whether the overall risk measure is value-at-risk (VaR), conditional value-at-risk (CVaR), tracking error or volatility.
There is no unambiguously 'best' measure of risk. VaR, CVaR, tracking error and volatility are essentially measures of a return (profit or loss) associated with a probability over a given time frame, such as 95% probability over one month. They each conceal as much as they reveal. Questions you might want to ask are:
Do they measure the likelihood of your target return being achieved or are they only measuring the likelihood of extreme loss? A 95% VaR, for example, indicates a loss that is expected to happen about once every 20 years. This tells you nothing about how the fund might behave in normal market conditions (in other words, most of the time). To understand the likelihood of achieving your target return, you would look toward the standard volatility measure (or tracking error if the fund is compared to a benchmark). Of course, if you really are interested only in avoiding extreme losses, you would leave your money in the bank.
Is the time frame suitable? A one-month VaR is of limited use if your investment horizon is three years (and vice versa).
What are the main sources of expected return? Investment managers usually have several – typically four to six – themes to their investment strategies. These are the drivers of return and risk. Too few themes means the fund may be too dependent on any one of them. Too many can be hard to manage, with the result that fund returns are likely either to be too volatile (if the risks compound each other) or to fall short of the target (if they are offsetting). Themes should be as independent as possible, bearing in mind that while few themes are entirely independent ('zero correlation' in risk-speak), some things are more related than others. Energy and transport, for example, have a strong, offsetting relationship; short-term interest rate risk is never far away from currency risk, so these two often compound each other.
Ideally, each theme should contribute according to the manager's conviction that it will succeed. No theme should dominate.
You will note that, so far, we have talked about linking risk with positive return. Most investments have about equal chances of making money and losing it, but some, such as uncovered sold options, harbour the potential for very large losses, so some control is clearly necessary to avert these.
Target returns and loss limits (which are not the same thing as stop-losses) for individual themes are not the best form of control because they are a sign that the portfolio manager links risks with return when composing the portfolio. A stated exit strategy for each theme, covering both good and bad outcomes, reflects discipline on the part of the investment manager – a crucial quality.
A robust risk management process is an invaluable resource. Not all talented portfolio managers are risk-savvy: many are exceptional at spotting individual opportunities but lose value by combining them in such a way that unwanted risk concentrations result. Remember that, unlike returns, risks do not add up: the portfolio's risk can be greater or less than the sum of the risks in it. Constructive risk management takes into account the complex, compounding and offsetting relationships between themes.
A skilled risk manager who understands the portfolio objectives and the portfolio manager's strengths and weaknesses can suggest ways to get rid of unwanted risks and so reduce volatility. With well-chosen risk tools, he can help allocate risk to the most promising themes, harnessing and enhancing the manager's skill and pinpointing weak spots that the portfolio manager may have missed.
This goes far beyond what can be achieved with 'dumb' controls. It need not be confrontational, and usually works better if it is not. For this, the risk manager needs to be at once independent of the portfolio manager and in a position of enough authority that his/her views are not easily dismissed.
To be most effective, the risk process needs to be accountable, so decisions and the rationale behind them are agreed and recorded to ensure that the right lessons are learned afterward.
Free lunches are scarce. While managers do exist who can earn near risk-free returns, the opportunities to do so are rare and never scalable. This means that you cannot earn more than basic returns without taking risk. As risk and return are inseparable, you must manage risk in order to manage return. If you do not, you are leaving yourself exposed to nasty surprises.
Enhanced oversight and regulation may benefit the industry by increasing investor confidence. But even the best thought-out rules and controls cannot substitute for careful information-gathering and common sense on the part of the investor. Finding out what you need to know means asking the right questions.
Frances Cowell is Director of Risk Consulting at R-Squared Risk Management, an independent, specialist risk management firm. Frances also serves on the board and is Company Secretary and Treasurer of London Quant, an organisation that provides a forum for discussion of practical issues in quantitative investment techniques. She is an Associate Member of the Chartered Institute for Securities and Investment and a member of CFA UK.
This article first appeared in Alternative Intelligence Quotient (Pg 21, Issue 34, June 2010). For more details, please visit www.alternativeiq.com