Hedge Funds and Risk Measurement (article)
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Hedge Fund Survey Overview
By Richard HorwitzCapital Market Risk Advisors, a financial advisory firm specializing in risk management, released the results of a recent survey on hedge funds as risk management. Hedge Fund Types Surveyed Participants include: Fund of Funds, Managed Futures, Risk Arbitrage, Long/ Short and Macro.
Approaches to risk management varied by hedge fund types.
Assets Under Management
Most respondents manage less than $500 million in onshore as well as offshore funds. No respondents manage more than $1 billion in offshore funds.
Assets by Class
The majority of respondents hold equity assets, with 70% holding international equity and 61% holding domestic assets.
Approximately 43% hold domestic fixed income assets and 33% hold international debt assets. Convertibles and distressed debt are held by approximately 15% of respondents.
Approximately 60% of respondents reported holding FX overlays.
Risk Management
Approximately 75% of respondents have a risk manager, though those that do not are not planning on adding a risk manager.
All respondents by the end of this year will have formalized their “risk appetite”.
An overwhelming majority of respondents have implemented a set of risk limits.
Risk Adjusted Performance
The majority of respondents measure risk-adjusted performance on an absolute basis. Those who do not measure risk adjusted performance generally do not plan to change.
Less than 50% of respondents measure risk-adjusted performance on a relative basis.
Sharpe and Sortino Ratios are the most widely used tools for measuring risk-adjusted performance.
Calculating / Measuring VaR
Approximately 70% of respondents will calculate VaR on an absolute basis by the end of this year.
However, only 13% of respondents calculated VaR on a relative basis.
The Variance/Covariance and Historical (Delta/Gamma) methods are the most widely used methods for calculating VaR.
Respondents applied differing holding periods to calculate VaR. Daily and monthly were the two most frequently selected.
Stress Testing
Scenario Analysis (actual scenarios such as the Russia/LTCM crisis and the Tequilla crisis) and Volatility Shifts are the two most widely used stress testing techniques.
Respondents are split on the frequency of stress-testing, though the majority stress test at least weekly.
Measuring Liquidity Risk
More than 80% of respondents measure liquidity — split relatively evenly among those that do it formally, those that do it informally and those that employ a hybrid of formal and informal means.
Informal measurement of liquidity risk is practiced at slightly higher levels than explicit measurement.
Whereas over 60% measure liquidity risk in terms of reduced volume on an informal basis, less than 40% do so on an explicit basis.
The majority of respondents will be aware of the dealers’ haircut methodologies by the end of the year.
Most respondents do not use and do not plan to use liquidity insurance.
Investors’ Interest in Risk Measures
Risk ratios are the most commonly reported risk statistic to investors, followed by leverage. VaR is currently only reported by 26% of respondents.
The majority of respondents have not increased their risk reporting since the LTCM crisis. The biggest increase has been in VaR and Risk Adjusted Performance.
Approximately 30% of respondents said that investors were asking for increased reporting on concentration measures.
Approximately 20% to 30% of respondents said that investors were requesting increased reporting on liquidity.
More than a third of respondents stated that investors have increased their demand for position-level information.
Richard Horwitz is a Vice President at Capital Market Risk Advisors, Inc., a consulting firm headquartered in New York that specializes in risk management, valuation, strategy, and independent risk oversight. Horwitz received his undergraduate degree in Electrical Engineering from MIT and his MBA from the Sloan School of Management at MIT.