Hedge Funds and Risk Transparency Make Strange Bedfellows

13th June 2012 by QFINANCE

Imagine a random collection of hot shot “boutique” (i.e small) fund management houses, each doing its own thing in its own, jealously guarded way. Then, over the top of this, layer two things, the first being the massively increased appetite for regulation from the political class and the second, investor demand for more transparency about risk.  The result, from the fund management house’s perspective is a very contradictory, but unignorable, confluence of pressures.

Hedge funds have traditionally been all about getting investors to invest fairly chunky sums on the back of promises of returns that dwarf what can be achieved by traditional, long only equity funds. Typically the fund’s strategy was a “black box”, described only by an opaque phrase or two, such as “statistical arbitrage” and investors bought in not because they had a clue about what the fund was doing or what risks it was running, but because it could demonstrate either a track record of mouth watering returns, or, in the case of newly launched hedge funds, the promise of out-performance, based perhaps on the reputation of the manager or managers involved.

This, of course, was precisely the environment that allowed Bernie Madoff to set up his criminal Ponzi scheme and siphon off some $60 billion of investor funds. It also allowed many other, legitimately run hedge funds, to deceive investors into believing that the manager had some magical formula for picking stocks or trading currencies when all they were doing in reality was massively leveraging the normal performance of a bull market.

Since investors are just as capable of leveraging returns, if they so wish, as a fund house, there was no particular reason why they should be paying 20% plus 2% charges to a fund house for doing this on their behalf. (Borrow £1 million, invest it in a market returning 5%, pay the bank interest of 3%, your return is a percentage of what you shelled out in interest, ie 66%. That looks fantastic when traditional funds are reporting returns of 5%, but there is nothing at all to the strategy apart from leverage.) When, post 2008, funds based on leverage turned in truly dismal results, the absence of any real strategy for generating alpha (outperformance) became unignorable. Investors became much more sceptical and started to ask a lot more questions of hedge funds. Of course, from the perspective of a hedge fund manager who really does have a decent strategy for outperformance, this increased investor scepticism is no bad thing. Properly addressed, it should make it much easier for them to raise funds since they really do have a good story to tell, and one that will stand up to scrutiny. But it is a sea change, none the less.

As Andrew Lo puts it, in an excellent paper entitled “Risk Management for Hedge Funds: Introduction and Overview“:

If there is one lasting insight that modern finance has given us, it is the inexorable trade-off between risk and expected return; hence, one cannot be considered without reference to the other.

Lo presents a very clear account of the different perspectives of institutional investors and hedge fund managers on risk.  Typically a hedge fund manager will feel that he/she is the best judge of the appropriate risk reward trade off in the portfolio (well, they would, wouldn’t they?), so external risk measurements are wide of the mark, or fail to take account of the subtleties of the fund manager’s approach. Institutional investors, by way of contrast, are increasingly working off a “risk budget” so they want to know how much risk they are running for the reward they expect to get. What this adds up to is a feeling on the part of hedge fund managers that risk management is subordinate to returns and that compliance is just a drag on performance.

In many instances this will be simply semantics. Institutions take account of the increased risk inherent in the asset class by only allocating a small proportion of their portfolio to hedge funds, unless they themselves are chasing returns! When you’ve allocated 5% to high risk outperformance do you really need to get into the minutiae of risk calculations beyond that? The fund either performs or it doesn’t and if it doesn’t you pick another fund. Or you pick a fund of funds manager who provides diversity across the universe of hedge funds. Beyond that, it’s all a bit academic, but hedge fund managers are learning that talking risk control is a very good way of attracting funds from institutions who have fiduciary responsibilities and are supposed to be micro managing risk. How real it all is, remains to be seen.

Further reading on alternative asset classes

This blog post was originally published on QFinance by Anthony Harrington.

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