Hedge-fund risk managers in the spotlight
The credit crunch is forcing a new mindset on hedge funds about how to fix the nuts and bolts of risk management.
The following article first appeared in the September 2008 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you canÆt find on our website, please send an e-mail to: [email protected].
The credit crunch is a æonce in a decade eventÆ. It is æa death by a thousand cutsÆ. Those are just two examples of the way that hedge-fund risk managers visualise this prolonged period of trauma; somehow ædislocation in the credit marketsÆ doesnÆt quite suffice.
Whatever term you prefer, these events have thrown the contribution of risk managers into sharp relief.
Hedge-fund risk managers are in the spotlight now in a way that they have never been before. The Asian economic crisis of 1997-98 was severe in its impact, but there was a fraction of todayÆs number of hedge funds then operating in Asia.
To some extent, investors who have done their due diligence properly already know about the risk policies and mechanics of their underlying hedge-fund investments. However, the circumstances have changed and the wiser investors are asking about risk parameters and how that reconciles with performance.
ôIntelligent questions are being asked by investors about risk,ö says Michael Schulz, a senior risk manager at CQS in Hong Kong. ôSome strategies might be extremely complicated though, and at some level the investor will have to rely on the fund managerÆs expertise to manage and control risk. To some extent, that is what the hedge fund is compensated for.ö
In other words, an investor might have numerous questions and ask for proof of risk strictures, but ultimately has to allow the fund to do what it has promised in enacting a complex strategy û perhaps one that the investor cannot replicate elsewhere.
Let us say for example that the strategy is convertible arbitrage. It might be a simple version of the strategy, going long on the bond and shorting the equity. Those positions are not hard to monitor. Single-issuer positions might involve stress tests, an assessment of value at risk and counterparty concentration reports û such concentration number perhaps based on a couple of daysÆ trading volume with that limit being reduced if volumes fall.
However, suppose the strategy is to play the æGreeksÆ around that convertible arbitrage trade. By introducing a long credit-default swap position, bingo, it becomes a gamma trade. Alternatively, instead of the long bond and long credit-default swap, you could buy a convertible bond option. These convertible-bond trading structures require a different kind of risk supervision, bespoke add-ons to the regular risk-management system. As you embrace more complicated strategies, the contribution of the information technology becomes more important. It is not easy for an investor to make an objective judgment about what plumbing lies behind these risk scenarios.
ôHedge funds are including historical simulations into their risk management in order to capture the effects of stressful market conditions in which correlation assumptions break down,ö says Lance Smith in New York, CEO of Imagine Software, a firm which builds complex risk systems. ôSome are also incorporating credit-default swap positions as a hedge, taking advantage of the wealth of CDS data now available to analyze historic relationships.ö
Your risk report, sir
If a difficult strategy like convertible arbitrage is hard to appraise, then even more difficult is the monitoring and measurement of non-exchange traded instruments, because for many instruments there is no price availability. Indicative prices are not indications of anything, and the mark-to-model is arguably delusional. There are whole areas of the market where no participant has an incentive to create a reportable arms-length transaction at any price, for fear of marking their existing books.
A hedge fund needs to be mindful of ôWhat limits we have committed to clients, and what limits are applicable internallyö. That means the difference between hard and soft limits. What is the process for reporting on limit violations and exceptions? As in investment banks, although a hedge-fund risk manager has reporting lines, he doesnÆt necessarily have the ability to physically trade out of a position himself independent of a trader in breach of a limit.
ôA hedge-fund risk manager still has to go through internal channels if there are limit violations,ö says Michael Schulz. ôHe canÆt just get on the phone and hedge out a position that is in excess. But, unlike an investment bank, a hedge fundÆs internal structure is usually smaller, flatter, allowing the remedial decisions and actions to be taken more quickly.ö
CQS does have one rock-solid fixed limit reportable to investors, and that is its value at risk as a percentage of net asset value. Internally, though desk limits do apply, CQS traders have to abide by sector and individual name limits, and æcurve limitsÆ.
Curve limits evaluate maturity mismatches. Liquidity and asset-liability mismatch are both key risk areas. Market risk is far more dependent now on liquidity and flow of funds than on fundamental factors. For hedge funds to establish what they can actually afford to hold to maturity is essential in this environment. In comparison to that, price risk is easy to analyse.
Stopping stop-loss losses
Stop-losses are a knotty area for risk-policy drafters. Investors like to see hard stop-loss rules. In Asia markets tend to be more volatile, and the whipsaw markets mean that hard stop-loss limits only serve to crystallise losses, by knocking the fund out of its position and forcing it to eat the loss. In many cases, markets will rebound; if the fund had been able to wait a day or two, it could have recouped at least some of its money.
Hedge funds are moving away from hard stop-loss rules, sometimes at the behest of investors who (ironically) say that they were far too over-cautious. The hard stop-loss limits might be replaced by wider bands, requirements to close out a smaller proportion of a position or flexible stop-loss rules based on historical volatilities.
The Hong Kong hedge fund Astrum Capital used to have a 20% away-from-cost hard-cut rule. Then it faced a whipsaw situation in late November 2007, in which the market suddenly and violently switched directions. The fund had been up that month, but because of having to cut its loss-making positions, it ended up 4% down. If Astrum hadnÆt had to cut positions, and simply held on to them as the market bounced straight back up again, that loss would never have been taken.
ôWhen an investmentÆs value goes against by 15% from cost, then I, as the risk officer, will first e-mail an alert notice to the portfolio manager,ö says Bosco Cheung, risk and compliance officer at Astrum Capital. ôThen, at 20% from cost, his position must be reduced by minimum of one third of the total size. At 30% away from cost, I will enforce the stop-loss without seeking further advice from the portfolio manager.ö
Leery of leverage
One more major component of the risk profile of a hedge fund, and one that investors are particularly concerned about, is the level of a portfolioÆs external borrowing.
ôInvestors today are worried more about leverage than value at risk,ö says Rocco Paduano, head of risk management at multi-strategy fund Hindsight in Hong Kong. ôThey are concerned about how much leverage your fund uses, rather than how you account for leverage; meaning, do you apply delta-adjusted utilisation of it or gross notional numbers. That distinction can be even more important than just the overall amount of leverage employed.ö
Hold on there. YouÆre a fund-of-hedge-funds analyst, and you have a box to tick on your list marked æleverageÆ, and now you are being asked to start thinking about the way a delta adjustment or a gross-position accounting methodology affects the outcome? Well, you should, because itÆs important, and without asking about the follow-up points, the original answer loses a lot of its meaning.
ôDelta-adjusted utilisations and limit calibrations are less conservative ways of monitoring risk than using gross notional position limits,ö explains Rocco Paduano. ôGross notional positions display larger risk numbers, therefore if you were deep out of the money, your delta-adjusted limit would show a lower leverage utilisation.ö
A couple of years ago, the æinÆ question to ask hedge funds was ôWhat is your vega?ö (ItÆs a measure of options). And the number would be given. However, very rarely asked was the logical follow-up question about the level of market exposure behind that number.
The point is, with risk matters you canÆt standardise the questions. The answers donÆt make a neat scientific fit into the box.
Whom can I trust?
A bread-and-butter area of risk that has come to the forefront in the credit crunch is that of counterparty risk, meaning broker settlement limits and prime broker exposure.
In the past a hedge-fund manager might not have given a lot of thought to this; to have done so would have required a lot of imagination. Instead most hedgies assumed that if the global economy faced a credit implosion, macroeconomic global collapse and soaring oil prices, his fund would have gone under long before his prime broker had gotten into trouble. Therefore, those risk managers trying to think ahead would have wanted to know what limits a prime broker was setting, and then pre-empt them.
Now, he might want to think about if he is prepared to take risk on his prime broker.
ôContingent credit exposure, especially counterparty and custodian exposure, is now much more a factor by necessity,ö says Paul Sheehan, CEO of event-driven fund Thaddeus Capital. ôMarket participants have been pricing these risks at effectively zero, which definitely helped eliminate market friction on the way up, but they are material non-zero risks. This alone makes many high-leveraged thin-spread trades accepted as bad bets now, versus a year ago.ö
With Bear Stearns not being permitted to fail, that gives some reassurance to users of the bigger prime brokers.
A recent Deloitte survey of hedge funds found that between 30-40% of them are not tracking liquidity; used value at risk without stress testing, back-testing or correlation testing; and had no industry concentration limits. Half of the funds hold assets with embedded leverage (such as forwards or derivatives) without measuring the off-balance sheet leverage. And 14% of hedge funds have no position limits whatsoever!
There have been hedge funds snuffed out by risk implosions but they do not get a lot of attention unless their demise threatens a major bank. In the wider world few are upset if a lot of rich investors lose millions in leveraged investment schemes. (In fact, some even get a degree of schadenfreude from it). Ironically, some of the more spectacular hedge-fund blowups were the hedge funds run by the big investment banks û most notoriously, of course, the two credit portfolios run into the ground at Bear Stearns.
One would have thought that the big investment banks would have brought world-class risk-management processes into the hedge funds that they managed, but sadly, that was not the case.
ôBig investment banks can certainly not claim any superiority in the risk-management arena,ö says the head of risk management at one US bank in Hong Kong. ôAfter all, who has been losing money in bucket loads, raising capital as if it is going out of style, and chopping off body parts to feed to the credit monsters? How many banks would be viable entities now, were it not for government backing? No one is coming to the rescue of any of the troubled hedge funds.ö
His conclusion: hedge funds donÆt have the safety net of accessing the US Federal ReserveÆs discount window, so their partners must manage their risk/return balancing act with greater care than investment banks have done.
The credit crunch is a æonce in a decade eventÆ. It is æa death by a thousand cutsÆ. Those are just two examples of the way that hedge-fund risk managers visualise this prolonged period of trauma; somehow ædislocation in the credit marketsÆ doesnÆt quite suffice.
Whatever term you prefer, these events have thrown the contribution of risk managers into sharp relief.
Hedge-fund risk managers are in the spotlight now in a way that they have never been before. The Asian economic crisis of 1997-98 was severe in its impact, but there was a fraction of todayÆs number of hedge funds then operating in Asia.
To some extent, investors who have done their due diligence properly already know about the risk policies and mechanics of their underlying hedge-fund investments. However, the circumstances have changed and the wiser investors are asking about risk parameters and how that reconciles with performance.
ôIntelligent questions are being asked by investors about risk,ö says Michael Schulz, a senior risk manager at CQS in Hong Kong. ôSome strategies might be extremely complicated though, and at some level the investor will have to rely on the fund managerÆs expertise to manage and control risk. To some extent, that is what the hedge fund is compensated for.ö
In other words, an investor might have numerous questions and ask for proof of risk strictures, but ultimately has to allow the fund to do what it has promised in enacting a complex strategy û perhaps one that the investor cannot replicate elsewhere.
Let us say for example that the strategy is convertible arbitrage. It might be a simple version of the strategy, going long on the bond and shorting the equity. Those positions are not hard to monitor. Single-issuer positions might involve stress tests, an assessment of value at risk and counterparty concentration reports û such concentration number perhaps based on a couple of daysÆ trading volume with that limit being reduced if volumes fall.
However, suppose the strategy is to play the æGreeksÆ around that convertible arbitrage trade. By introducing a long credit-default swap position, bingo, it becomes a gamma trade. Alternatively, instead of the long bond and long credit-default swap, you could buy a convertible bond option. These convertible-bond trading structures require a different kind of risk supervision, bespoke add-ons to the regular risk-management system. As you embrace more complicated strategies, the contribution of the information technology becomes more important. It is not easy for an investor to make an objective judgment about what plumbing lies behind these risk scenarios.
ôHedge funds are including historical simulations into their risk management in order to capture the effects of stressful market conditions in which correlation assumptions break down,ö says Lance Smith in New York, CEO of Imagine Software, a firm which builds complex risk systems. ôSome are also incorporating credit-default swap positions as a hedge, taking advantage of the wealth of CDS data now available to analyze historic relationships.ö
Your risk report, sir
If a difficult strategy like convertible arbitrage is hard to appraise, then even more difficult is the monitoring and measurement of non-exchange traded instruments, because for many instruments there is no price availability. Indicative prices are not indications of anything, and the mark-to-model is arguably delusional. There are whole areas of the market where no participant has an incentive to create a reportable arms-length transaction at any price, for fear of marking their existing books.
A hedge fund needs to be mindful of ôWhat limits we have committed to clients, and what limits are applicable internallyö. That means the difference between hard and soft limits. What is the process for reporting on limit violations and exceptions? As in investment banks, although a hedge-fund risk manager has reporting lines, he doesnÆt necessarily have the ability to physically trade out of a position himself independent of a trader in breach of a limit.
ôA hedge-fund risk manager still has to go through internal channels if there are limit violations,ö says Michael Schulz. ôHe canÆt just get on the phone and hedge out a position that is in excess. But, unlike an investment bank, a hedge fundÆs internal structure is usually smaller, flatter, allowing the remedial decisions and actions to be taken more quickly.ö
CQS does have one rock-solid fixed limit reportable to investors, and that is its value at risk as a percentage of net asset value. Internally, though desk limits do apply, CQS traders have to abide by sector and individual name limits, and æcurve limitsÆ.
Curve limits evaluate maturity mismatches. Liquidity and asset-liability mismatch are both key risk areas. Market risk is far more dependent now on liquidity and flow of funds than on fundamental factors. For hedge funds to establish what they can actually afford to hold to maturity is essential in this environment. In comparison to that, price risk is easy to analyse.
Stopping stop-loss losses
Stop-losses are a knotty area for risk-policy drafters. Investors like to see hard stop-loss rules. In Asia markets tend to be more volatile, and the whipsaw markets mean that hard stop-loss limits only serve to crystallise losses, by knocking the fund out of its position and forcing it to eat the loss. In many cases, markets will rebound; if the fund had been able to wait a day or two, it could have recouped at least some of its money.
Hedge funds are moving away from hard stop-loss rules, sometimes at the behest of investors who (ironically) say that they were far too over-cautious. The hard stop-loss limits might be replaced by wider bands, requirements to close out a smaller proportion of a position or flexible stop-loss rules based on historical volatilities.
The Hong Kong hedge fund Astrum Capital used to have a 20% away-from-cost hard-cut rule. Then it faced a whipsaw situation in late November 2007, in which the market suddenly and violently switched directions. The fund had been up that month, but because of having to cut its loss-making positions, it ended up 4% down. If Astrum hadnÆt had to cut positions, and simply held on to them as the market bounced straight back up again, that loss would never have been taken.
ôWhen an investmentÆs value goes against by 15% from cost, then I, as the risk officer, will first e-mail an alert notice to the portfolio manager,ö says Bosco Cheung, risk and compliance officer at Astrum Capital. ôThen, at 20% from cost, his position must be reduced by minimum of one third of the total size. At 30% away from cost, I will enforce the stop-loss without seeking further advice from the portfolio manager.ö
Leery of leverage
One more major component of the risk profile of a hedge fund, and one that investors are particularly concerned about, is the level of a portfolioÆs external borrowing.
ôInvestors today are worried more about leverage than value at risk,ö says Rocco Paduano, head of risk management at multi-strategy fund Hindsight in Hong Kong. ôThey are concerned about how much leverage your fund uses, rather than how you account for leverage; meaning, do you apply delta-adjusted utilisation of it or gross notional numbers. That distinction can be even more important than just the overall amount of leverage employed.ö
Hold on there. YouÆre a fund-of-hedge-funds analyst, and you have a box to tick on your list marked æleverageÆ, and now you are being asked to start thinking about the way a delta adjustment or a gross-position accounting methodology affects the outcome? Well, you should, because itÆs important, and without asking about the follow-up points, the original answer loses a lot of its meaning.
ôDelta-adjusted utilisations and limit calibrations are less conservative ways of monitoring risk than using gross notional position limits,ö explains Rocco Paduano. ôGross notional positions display larger risk numbers, therefore if you were deep out of the money, your delta-adjusted limit would show a lower leverage utilisation.ö
A couple of years ago, the æinÆ question to ask hedge funds was ôWhat is your vega?ö (ItÆs a measure of options). And the number would be given. However, very rarely asked was the logical follow-up question about the level of market exposure behind that number.
The point is, with risk matters you canÆt standardise the questions. The answers donÆt make a neat scientific fit into the box.
Whom can I trust?
A bread-and-butter area of risk that has come to the forefront in the credit crunch is that of counterparty risk, meaning broker settlement limits and prime broker exposure.
In the past a hedge-fund manager might not have given a lot of thought to this; to have done so would have required a lot of imagination. Instead most hedgies assumed that if the global economy faced a credit implosion, macroeconomic global collapse and soaring oil prices, his fund would have gone under long before his prime broker had gotten into trouble. Therefore, those risk managers trying to think ahead would have wanted to know what limits a prime broker was setting, and then pre-empt them.
Now, he might want to think about if he is prepared to take risk on his prime broker.
ôContingent credit exposure, especially counterparty and custodian exposure, is now much more a factor by necessity,ö says Paul Sheehan, CEO of event-driven fund Thaddeus Capital. ôMarket participants have been pricing these risks at effectively zero, which definitely helped eliminate market friction on the way up, but they are material non-zero risks. This alone makes many high-leveraged thin-spread trades accepted as bad bets now, versus a year ago.ö
With Bear Stearns not being permitted to fail, that gives some reassurance to users of the bigger prime brokers.
A recent Deloitte survey of hedge funds found that between 30-40% of them are not tracking liquidity; used value at risk without stress testing, back-testing or correlation testing; and had no industry concentration limits. Half of the funds hold assets with embedded leverage (such as forwards or derivatives) without measuring the off-balance sheet leverage. And 14% of hedge funds have no position limits whatsoever!
There have been hedge funds snuffed out by risk implosions but they do not get a lot of attention unless their demise threatens a major bank. In the wider world few are upset if a lot of rich investors lose millions in leveraged investment schemes. (In fact, some even get a degree of schadenfreude from it). Ironically, some of the more spectacular hedge-fund blowups were the hedge funds run by the big investment banks û most notoriously, of course, the two credit portfolios run into the ground at Bear Stearns.
One would have thought that the big investment banks would have brought world-class risk-management processes into the hedge funds that they managed, but sadly, that was not the case.
ôBig investment banks can certainly not claim any superiority in the risk-management arena,ö says the head of risk management at one US bank in Hong Kong. ôAfter all, who has been losing money in bucket loads, raising capital as if it is going out of style, and chopping off body parts to feed to the credit monsters? How many banks would be viable entities now, were it not for government backing? No one is coming to the rescue of any of the troubled hedge funds.ö
His conclusion: hedge funds donÆt have the safety net of accessing the US Federal ReserveÆs discount window, so their partners must manage their risk/return balancing act with greater care than investment banks have done.
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