Understanding Hedge Fund Risks

There are risks to all forms of investing, especially in hedge funds. The Principles and Best Practices for Hedge Fund Investors lists what those risks are and how to recognize them.

Investors should be sufficiently familiar with these forms of risk to recognize their impact upon a particular hedge fund and its trading strategies.

Market and Market-Related Risks

      • Equity risk is the risk that a portfolio will change in value due to fluctuations in equity prices. Hedge fund managers can manage equity risk through hedging strategies that utilize equity derivatives such as options and futures contracts or by employing market-neutral investment strategies that generally do not correlate with broad market movements and, thus, carry limited broad market risk.
      • Interest rate risk is the risk to portfolio value due to changes in interest rates. Interest rate risk can be hedged with a variety of techniques and financial instruments, including futures contracts and swap agreements. It is quite possible that the hedging of interest rate risk of certain investments, with instruments that have different proportions of risk exposures, can result in exposure to forms of basis risk.
      • Currency risk is the risk of changes in the relative value of a foreign currency in which investments are denominated. This risk directly affects the value of such investments. Currency risk can be offset using forward or futures contracts as hedges against foreign exchange rate fluctuations.
      • Credit risk is the risk of default of an underlying borrower. Depending on the nature of the borrower, there can be consumer credit risk or corporate credit risk. Consumer credit risk is particularly relevant to the origination market where, for example, investors holding structured pools of mortgages have credit exposure to the underlying borrowers. Corporate credit exposure arises, for example, when an investor owns fixed-income securities issued by a corporation. The expected cash flows from these securities are dependent on the financial condition of the issuer. Additionally, relying solely on third-party credit rating providers can expose a portfolio to rating agency risk.
      • Commodity risk refers to the risk of rising or falling commodity prices that may result from supply and demand imbalances, changing spending patterns, or changing input costs. Commodity risk can be contained through futures and forward commodity contracts.
      • Volatility risk arises from increased market price fluctuations. Managing volatility risk in normal environments can be accomplished through portfolio diversification by market sector and strategy. Volatility risk emerges on a different level under extreme market conditions in which correlations between asset classes and strategies tend to change and often converge. Managers may hedge volatility risk through financial derivatives.
      • Correlation risk is the risk of changes in the way prices of different investments in a portfolio relate to each other. Increasing correlations can attenuate the expected benefits of diversification.
      • Liquidity risk, in its “market” form, is the risk of being unable to unwind investment positions at previously prevailing market prices. In a sudden market downturn, margin calls can force the liquidation of portfolio positions. When combined with contracting liquidity arising from hedge fund redemptions, this environment leads to large cash outflows and greater portfolio losses. Because of its tendency to compound market, credit, and other risks, it is difficult to isolate liquidity risk. Market liquidity can suddenly and severely contract, making it difficult to transact at “observed” market prices. For example, bid-ask spreads may be so wide that fund NAVs may not be realistic if a fund actually seeks to sell positions. Where appropriate, liquidity risk measurement should reflect the potential discounts in value that would effectively incorporate the potential impacts of severe market changes. Liquidity risk has additional bearing in the hedge fund context for fund strategies that involve the purchase of less liquid assets coupled with hedging short positions in more liquid instruments. Hedge funds following this strategy get compensated for acting as liquidity providers to the markets.

Other Investment Risks

      • Basis risk refers to the risk remaining after hedging has been implemented. Certain investment opportunities may not allow for effective hedging, and hedge funds may be able to hedge some components of risk but not others. Theoretically, perfect hedging should result in a return equal to the risk-free rate, minus transaction costs. Generally speaking, there will always be some basis risk in hedged investments.
      • Common holder risk results where many investors holding the same asset need to exit it at the same time, resulting in significant downward price pressure.
      • Event risks are those unusual circumstances in which large-scale swings occur in capital markets. These may arise from unpredictable events such as terrorist attacks, natural disasters, unusual weather patterns, or oil supply shocks. To analyze extreme event risk, a hedge fund manager should employ a series of hypothetical scenarios that are relevant to the particular portfolio. Examples of market stress events may include rapid equity declines and credit-spread widening or a period of rapid equity advances and credit tightening. Managers should conduct appropriate stress testing based on the current portfolio exposures and specifics.
      • Counterparty risk arises from transacting with parties that are unable to meet their obligations. It is particularly important when investing in derivatives, in which either party’s credit exposure to the other will change, perhaps significantly, over the term of a derivative contract. Managers can generally mitigate or diversify counterparty risk on two levels. First, they should choose counterparties with strong balance sheets and consistent cash flow streams. Second, they may be able to use security interests in collateral, covenants, and credit derivatives, such as credit default swaps or other types of protection, to support the timely and orderly repayment of financial obligations. Investors should understand the manager’s policies for selecting and monitoring counterparties.
      • Asset/liability matching risk, sometimes referred to as funding liquidity risk, is the risk of loss when the amount of capital available to a hedge fund falls due to redemptions or the loss of other financing sources and the hedge fund cannot fund its redemptions, investments, payments to creditors, or expenses. Investors assessing this risk must consider the investment strategies employed, the nature of the fund’s investor base, the rights of investors to redeem their interests, asset liquidity, and counterparty funding arrangements.
      • Meta risks are the qualitative risks beyond explicit measurable financial risks. They include human and organizational behavior, moral hazard, excessive reliance on and misuse of quantitative tools, complexity and lack of understanding of market interactions, and the very nature of capital markets in which extreme events happen with far greater regularity than standard models suggest. While these qualitative risks exist and it is useful to be aware of them, it is virtually impossible to plan for and hedge against them.

Principles and Best Practices for Hedge Fund Investors

Looking at the second page of the report you will find that one of the members of the Investor’s Committee that wrote it is Andy Golden. Andy is the President of the Princeton University Investment Company (PRINCO). He was also a guest on Capital Allocators.

Episode 13:  Andrew Golden – Beyond the Long Term

Bridal Veil Falls, Yosemite and Fallen Bierstadt inside the Princeton Art Museum.
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Post by Marcelino Pantoja