A year ago a good name and an impressive track record were all a hedge fund manager needed to attract investors. Today that same manager is under pressure to demonstrate risk controls before most investors will hand money to, or even keep money with, his firm.
Brian Schmid, head of alternative-investment business strategy at RiskMetrics Group, a New York–based firm that does risk analysis for funds and investors, says most hedge funds have adapted to the new reality and are more willing than they used to be to provide such information. They cooperate for one major reason, he says: to stay in business.
RiskMetrics counts among its clients many of the top 50 funds in Alpha ’s Hedge Fund 100 ranking of the world’s biggest hedge fund firms (May 2008), a following it has gained by promoting itself as a third-party service that feeds risk analysis to investors without revealing the positions a particular fund holds. The process is straightforward: Funds upload their positions to RiskMetrics at the end of each business day, the company runs an overnight risk analysis and delivers it to the fund’s investors in the morning, and investors can tell whether a fund is, say, reasonably hedged against a big position in the banking sector. “Two years ago roughly 50 percent of the hedge funds asked by an investor would be willing to participate in the process, whereas now 85 percent of the hedge funds invited to participate by an investor are willing,” Schmid notes.
Demand for services like RiskMetrics’ will increase this year, predicts Blaise Labriola, a managing director of Altaira, a New York–based risk and portfolio management firm. Hedge funds will be expected, among other things, to closely monitor the counterparty risk of their prime brokers, a switch from the past — before the demise of Bear Stearns Cos. and Lehman Brothers Holdings. “It used to be the sell-side firms did that, but now the hedge funds have to,” he says. Firms will have to track the obligations a prime broker has, for example, in credit default swaps.
It is all part of a growing awareness that the world has changed. “A market like this rewrites all the rules,” argues Labriola.
The key to reassuring investors may lie in transcending previous practices. “Hedge funds with homegrown risk systems won’t get money,” he asserts. “Homegrown is not going to fly anymore.”
Most experts also say hedge funds must do more than simply calculate traditional value at risk, commonly known as VaR, which follows standard, and perhaps outdated, mathematical formulas to gauge the vulnerability of a portfolio (see “Tails, You Lose,” September 2008). The new world of risk management demands that managers expand their view of what-if scenarios and include more sensitivity to credit spreads and interest rates, for instance. Managers are being encouraged, too, to run more models that jolt portfolios with extreme shocks to see, as Labriola puts it, “if you are still in business or blown out.”
If all of this has a doomsday feel, it’s because worst-case possibilities are not as implausible as they once were. “You now need to know what happens if the U.S. defaults on its debt — that is a scenario you would not normally have run before this,” says Hans Hufschmid, director and CEO of GlobeOp Financial Services, a London- and New York–based fund administrator. “Today you have new extremes, conditions you never thought were in play but now are.”
Executives at RiskMetrics are seeing heightened imagination among hedge fund managers and more interest in a line of tests the firm has designed to measure how vulnerable a fund may be to any number of extreme circumstances. And funds are working harder in-house to envision what could go wrong.
“A year ago three out of five were creative, and now we see ten of ten are more creative in the stress-testing they are developing,” Schmid says. “There’s more of a culture of risk. Risk management is getting upper-management buy-in.”
Investors, too, are showing increased vigilance, says Marcel Melis, CEO of Amsterdam-based Energy Capital Management, which favors highly liquid holdings, maintains low volatility and has a strong culture of risk management (half of the hedge fund firm’s Web site is devoted to risk practices and reporting).
But its clients are still pushing Energy Capital. “Because of current market circumstances, investors are conducting even more extensive due diligence,” says Melis. This heightened demand comes despite the fact that the firm does a lot already — monthly letters to investors, conference calls, detailed risk management reports and weekly net asset value estimates prepared by a third-party administrator.
At London-based Lab49, a software firm that relies on hedge funds for about 15 percent of its business, managing director Vivake Gupta notes a historical reluctance among firms to embrace full-blown risk management — probably because it is so complex and expensive. But, like Altaira’s Labriola, he sees a shift, mostly because of raw market forces; Gupta says funds will place more emphasis on risk management while they look for ways to recover from a dismal year. “The models for alpha have been momentum, but the momentum model is broken,” he asserts.
GlobeOp’s Hufschmid says what constitutes a reputable level of risk management at a fund depends on what strategy or strategies it is running. A firm that follows a largely macro approach may not require an overly sophisticated system, because its main concerns may be limited to currency valuations and interest rates. “But a complex strategy using credit, convertible bonds, bank debt or something like that, they have to have a very, very sophisticated risk system,” he explains. “They will spend a lot of time and energy on risk because that will drive what they buy and sell.”
Hufschmid adds that much of the demand for better risk management comes from investors who are simply asking for more transparency, seeking a better idea of what exactly a manager is doing. He is quick to promote GlobeOp for its ability to verify a fund’s positions rather than just take its end-of-day feeds and report the bare-bones information (the company says it has access to hedge fund positions and can reconcile them with published prices and prime broker data). This allows GlobeOp to see whether a manager has drifted away from his stated strategy, which can be of considerable concern to investors.
“The manager is not going to call and tell me if he changes his trading style,” Hufschmid says. “But if I am building a portfolio of hedge fund managers, it is important for me to know if they change styles so I can control my allocation. If the long-short manager starts trading foreign exchange, then I will want to take my money away from him.”
