Derivatives and hedging are tools that remain necessities in the financial system as a way to manage risks that might arise from uncertainties and price fluctuations in the market, although it remains a contentious subject in Islamic finance due to some of the features in the instruments that invite speculative trading. Views are often split from a Shariah standpoint, given that excessive uncertainty and speculation are concepts not permissible in Shariah compliant transactions.
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.
Discussions brewing among Islamic bankers about the direction Islamic finance should take could have implications in several areas, not least the risks their banks will face and the risk management measures they have in place.
Hedge fund strategies in a UCITS wrapper have become very popular among investors in recent years and more so since the financial crisis. Indeed, the proposal looks appealing as it is supposed to bring onshore in a regulated framework the hedge fund benefits which were previously available offshore and only for accredited investors. Furthermore, the UCITS framework apparently provides answers to investors’ current worries concerning transparency, liquidity, asset safekeeping and risk management.
Author and specialist financial derivatives Nassim Nicholas Taleb was recently quoted extensively in a New York Times article titled “Risk Mismanagement”. He makes some valid points with regard to the usefulness of risk metrics at times of extreme market behaviour. But while VaR certainly has its laundry list of problems, Taleb takes VaR out of context by focusing on only one version : the Gaussian-based parametric VaR which he rightly points out is severely constrained by the dangerous assumption that asset returns follow a normal bell-shaped distribution.
It is no secret that 2008 was one of Wall Street’s toughest years and perhaps the most challenging year ever for hedge funds. Evidence of this can be found in the dismal performance of the Barclay’s Hedge Fund and Fund of Funds indices, both down almost 21%. Many funds blew up, including Sailfish, Peloton and others. As the year closed, serious allegations of fraud were levied against one of the most famous and respected hedge fund managers, Bernard Madoff. While it is too early to count all of the casualties, the preliminary numbers paint a rather bleak picture.
Whenever we have a crisis in the financial markets and inordinate amounts of wealth are lost, the cry goes up, “How could this have happened? What were the governments doing? It’s all the fault of those greedy fat-cats on Wall Street.” Take a historical look at all the major financial crises in the past 100 years and the same clumsy song and dance routine between investors, fund managers, bankers, governments and regulators is played out.
The recent outperformance of commodities versus equities has caused a positive re-evaluation of commodities by both retail and institutional investors. Since December 2001, the annualised performance of commodities as represented by the Goldman Sachs Commodity Index (GSCI) has been +26.2% while the annualised performance of equities as represented by the S&P 500 equity index has been +3.8%.
Risk control is a complex subject, and an area where simple and robust guides are particularly valuable. Few concepts are simpler and more intuitive than the stoploss, and it has taken a vice-like grip on some investors' approach to the subject. During investor meetings, I have even been asked: "Let us talk about risk control... what kind of stoploss do you use?"
Unfortunately, despite its appeal the stoploss is no panacea. In fact, it is not even a good system for the vast majority of portfolio investors, as a simple simulation will illustrate. The stoploss rule I will consider is that any position is automatically closed when it loses more than a certain fixed percentage from the initial price at which the trade was made.
As hedge funds continue to become more institutionalised, sponsors are adjusting their risk management strategies to manage growth in a way that safeguards the firm’s reputation and maintains operational efficiency.
Firms are tailoring their risk management programs to achieve an optimum balance between fostering growth and ensuring proper control over investment and operational risks.
Risk management is still a new concept in the alternative investment community, particularly in Japan. Unfortunately, there is no textbook definition of risk management just like there is no textbook definition of corporate management or fund management; which further complicates how risk management is implemented. These terms merely reflect the culture and philosophy of the management team, which uses its skills running a business. Risk management therefore reflects the culture of the company or fund that the management team has already established.