Hedge fund risk management

This article gives you an idea about what are the relevant factors for Hedge Fund Risks fundamentals.
What are risk fundamentals?
Webster's Dictionary defines "fundamental" as:
1 One of the minimum constituents without which a thing or system would not be what it is;
2 Of or relating to essential structure, function, or facts; or
3 Of central importance.
The term risk fundamentals, as used here, is a triple entendre, referring to:
-- Fundamental risk principles
-- Fundamental risk measures
-- The Risk Fundamentals Solution
Fundamental risk principles
Here are the fundamental risk principles:
Volatility which results from uncertainty of returns. The greater the volatility, the greater the risk. In general, the greater the risk, the greater the potential returns. Diversification reduces risk without necessarily reducing returns.
Leverage enhances returns while commensurately increasing risk. Liquidity is a risk for which hedge funds can be compensated. However, illiquid instruments/portfolios, especially when combined with leverage, can have significant "blow-up" risk.
Both funds and investors should measure risk in all market conditions. Historical simulation helps you analyse the behaviour of a portfolio in normal market environments. Stress testing allows you to analyse the behaviour of a portfolio in crisis market environments.
Both funds and investors should understand the source of risk. A risk factor framework is an additive framework to explain and communicate risk, which is inherently non-additive (which is why 1+1 doesn't equal 2). Risk is amorphous and difficult to communicate. Visualising and articulating risk is as important as analysing it. Hedge funds should develop a rink culture that nurtures the taking of attractively compensated risk.
Risks other than those related to market performance are never compensated. Non-market risks should be minimised or avoided. Hedge funds should target idiosyncratic risk exposures through security selection ("stock picking" in the equity world). Hedge funds should actively manage their exposures to market and secondary risks in constructing a fund.
Attributing performance by applying the same risk factor framework upon which portfolio constructions are based provides an understanding of how a fund has made money. Risk budgeting is a holistic approach embraced by many large institutional investors. It integrates risk management with other investment processes.
NAV/return reporting is currently inefficient, incomplete, imprecise, and misleading. Investors have created portfolios of funds by "stacking" funds with good trailing returns. Instead, investors should proactively construct a risk-efficient portfolio of hedge funds.
Investors should perform comprehensive risk due diligence as part of the initial manager selection process and should continue to update it as part of their routine monitoring process.
Transparency permits investors to fundamentally understand the risks they are taking.
As proven in many other industries, universal, cost-efficient risk transparency within the hedge fund industry will require an industry standard solution.
FUNDAMENTAL RISK MEASURES
In the financial world, business fundamentals are the essential measures that characterise the behaviour of a company. For example, company's financial fundamentals are the key balance sheet, profit and loss (P&L), and cash flow measures that characterise the financial well being of the company and explain the market behaviour of its securities. These are the key statistics that are used in fundamental research.
Similarly, risk fundamentals are the key measures that characterise the risk and return behaviour of an investment. To understand the potential value of risk fundamentals to a hedge fund analyst, consider the value of company fundamentals to an equity analyst. Which would an equity analyst performing fundamental research prefer?
-- Hard copies of every invoice in their raw form (thirteen tons of paper delivered in a tractor trailer); or
-- Net revenues by line of business for the past twenty quarters from the lOQs (sixty summary statistics presented in a spreadsheet)?
The answer is obvious. The reason that companies report fundamental financial information is to efficiently communicate the essential performance characteristics of the business. Furthermore, financial fundamentals do this without compromising proprietary data. For example, if the company had opted to deliver the truckload of hard copies, this information would have inadvertently revealed the pricing provided to each and every customer. As this became public, customers who were receiving less favourable prices would be up in arms. So providing every detail would not have successfully communicated the essential information, and it would damage the company by disclosing sensitive data.
Now consider the fundamentals you would want to see when comparing the risks of hedge fund investments. Which would better explain the risk associated with an investment?
-- A haphazard and inconsistent presentation of the details of each and every position in the portfolio; or
-- A structured presentation of standardised summary risk statistics?
The answer is equally as obvious. As with the company financial information, less is more. A select set of summary, standardised statistics is more valuable than comprehensive, detailed, unstructured data. It is significantly more valuable to provide synthesised risk fundamentals than to inundate the investor with raw data that do not fundamentally explain the risks of the investment. Furthermore, fundamental risk data do not compromise proprietary details.
The hedge fund industry, investors, and regulators have been actively debating risk transparency for more than five years (since the Long-Term Capital Management crisis in the fall of 1998), but little concrete progress has resulted. In achieving quality transparency within the hedge fund industry will require the adoption of an industry standard reporting framework.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates.)