Addressing Hedge Fund Risk:  
From the Perspective of An Allocator  

Virginia Reynolds Parker, CFA
President
Parker Global Strategies

I was first introduced to hedge fund investing and the concept of risk management oversight in the summer of 1988. At the time, I was running very vanilla equity and fixed income portfolios for a family office. What attracted me to hedge funds was the potential ability to make profits in both up and down markets. The previous fall of 1987, we had witnessed just how quickly the U.S. equity market could implode, spiraling down exponentially with the reverse thrust of portfolio insurance, as market participants watched in awe. Of course the equity market recovered quickly, and for those invested, delivered very handsome profits for many years to come. One really did not need hedge funds over the coming years; a long only S&P portfolio out performed a number of hedge fund strategies for many of the next twelve years. Nonetheless, I appreciate the timing of my educational sojourn into this niche of market investing. I have seen the performance of various hedge fund strategies over several economic cycles, the savings and loan crisis, the Gulf War, the 1994 and 1997 collapses of emerging market economies, the default of Russia, the demise of Long Term Capital Management, and the burst of the technology bubble. Looking back on my experience and observations over the years, I have healthy skepticism and cautious optimism.

 The approach of our firm, Parker Global Strategies, to hedge fund investing and risk management oversight is considerably different than most investment boutiques specializing in this area. Our investment approach and process are built on our philosophical foundation stressing the importance of risk management through a three pronged approach stressing diversification, transparency and independent oversight for our investments. We have heard much discussion in the industry about the institutionalization of hedge funds. We believe our approach is the proper institutional approach to hedge fund investing. The approach is similar to that followed by some of the banks providing hedge fund investments to their clients; this is especially true for some of the banks offering these investments via structured products. The benefits of this three pronged approach may be appreciated and realized by individual investors as well, who may choose to rely on fund of funds or hedge fund consultants to assist them in gaining exposure to hedge funds along with independent risk monitoring.  

Diversification
Thoughtful diversification, diversification that holds up from both a qualitative and a quantitative perspective, is the most rudimentary building block for portfolio construction and management. Many portfolio mistakes may be survived if one has achieved meaningful diversification. In the case of hedge funds, this means diversification across strategies, managers, markets, and risk factors. If one examines

the performance of the HFR Indexes, representing the average performance of various hedge fund styles, one notes the cyclical nature of these styles. Economic events, market events, and political events create ebbs and flows of profit opportunity for the various styles. Carefully constructed portfolios may include directional strategies, spread dependent strategies, and managed futures strategies that, when combined, may withstand many market environments. Portfolio construction cannot necessarily prevent losses, but careful diversification may help lessen losses during market crises. In constructing the portfolio, one must recognize the various risks of each strategy. One must address the event risk that is often missing through a purely quantitative view of past performance. One must question the integrity of the portfolio’s pricing, or marks-to-market. After all, portfolio NAVs are based upon a mark-to-market of each position, representing a moment in time, when the positions may have been sold at the “assigned” price. Or, the “assigned” price may have failed to recognize the large size of a position, the illiquidity of the market, the complexity of the derivative security, the flaw in the pricing model, or the circular reference of “independent broker/dealer pricing. These pricing issues are but a few of the many pricing issues that an allocator to hedge funds should comprehend prior to selecting strategies and managers. As a rule of thumb, the more complicated the strategy and the less liquid the portfolio, the more knowledgeable and wary the allocator should be.

 One also must be aware of potential concentration risk. Some managers of managers and fund of funds address diversification by selecting 50 to 100 hedge funds for a single portfolio. Although this method may be very effective, our firm’s preference is to hire a “manageable” number of hedge fund managers for a portfolio, where we can monitor each manager’s underlying portfolio regularly and monitor the diversification in the portfolio from a quantitative perspective, as well as ongoing qualitative, perspective. We believe that one may build a well diversified portfolio with twelve to fifteen managers. 

Transparency
Transparency is important for understanding past performance, and transparency is important for understanding current performance and portfolio risks. What is transparency? It is the willingness of the hedge fund manager to provide full disclosure of portfolio positions, along with pricing, and methodology of pricing, preferably directly from the prime broker who represents an independent source. Transparency also includes the investor’s ability to examine all agreements to which the hedge fund company is a party. Such agreements include, but are not limited to, the prime brokerage and other counterparty agreements, the administration agreement, the engagement letter with the auditors, past audit reports, the registrar and transfer agreement, side letters for existing investors, and corporate registrations. Additionally, the hedge fund manager should be willing to disclose the monthly redemption and subscription history for the fund since its inception.

Portfolio transparency is the tool for getting behind the numbers in hedge fund investing. Neophytes will chase performance, taking reported numbers at face value. For those who have been allocating over a number of years, understanding how the numbers were generated, and in fact, if the numbers were generated, is imperative to successful hedge fund investing. So many of the old adages also hold true for hedge funds, if it [performance] looks too good to be true, it very likely is. Today we find many more hedge funds willing to offer some meaningful level of transparency when compared to what managers would provide back in the late 1980s. So many managers are willing to provide some meaningful level of portfolio transparency that one may build a strong multi-manager program without sacrificing returns.          

Independent Oversight
Completing the risk management paradigm for hedge fund investing requires regular, independent risk oversight. This regular monitoring of the portfolio requires transparency of positions so that one may assess the risk in the portfolio. There is much discussion today by those who believe risk exposures may be adequately monitored without the benefit of the underlying positions. With this view, I respectfully disagree. With risk exposures, one may achieve a very general sense of the portfolio. But if risk exposures without positions were truly able to capture detailed portfolio risk, we would likely see modification of “best practices” for dealers and end users. If limiting transparency to risk exposures were really sufficient, why wouldn’t prime brokers monitor their own risk to hedge funds in such a way? Risk exposures provide a high level risk assessment, but the allocator and/or independent risk manager needs drill down capability to be able to probe portfolio issues. 

Risks that should be evaluated regularly include market risk and various operational risks. Current “best practices” for assessing market risk include independent portfolio pricing; VaR by position, market, asset class, manager, and strategy; monte carlo simulations for portfolios containing optionality; and stress testing. One should examine concentrations of risk in the portfolio and key performance drivers. One must also evaluate liquidity risk. Although leverage is an ambiguous term across hedge fund strategies, one should measure the gross and net exposures, in aggregate and across industry sectors, for long short equity portfolios. For interest rate and fixed income positions, one must examine exposures across yield curve buckets and credit quality. For arbitrage strategies, one must dissect spread risk. In the late 1980s, risk measurement analytics were barely developed and required massive computing power along with a team of rocket scientists. Fortunately today, the risk manager may choose from off the shelf software, prime brokers, and even ASPs as a source of the risk measurement analytics. A risk manager must simply have the skill to understand the reports and the experience to know when to intervene.

 Depending upon the particular circumstance, one may pursue independent oversight with, or without, some control. The best control for the allocator is investing via a managed account with the hedge fund. However, a managed account is not always possible or practical. Hedge fund managers often require very high minimum account sizes to run a managed account; some hedge fund managers are unwilling to run a managed account. Some investors, for regulatory or tax reasons are required to invest via a fund, and may be limited to the percentage ownership that they may represent to the total fund. Generally, with a managed account, the allocator may terminate the hedge fund manager immediately, and/or intervene in the portfolio. In a fund investment, the allocator’s control is usually limited to redeeming on the next redemption date, provided the allocator has provided sufficient notice to the fund. 

Summary
What is the edge provided by this three pronged approach to risk management? Having practiced this methodology for over a decade now, I have witnessed several important advantages. First and most important, one has a full set, or nearly full set, of information with which to make informed decisions much earlier than if one merely waited for the arrival of the monthly NAV to begin analyzing facts and asking questions. Where such timely information cannot prevent losses, often losses may be slowed, because action may be taken sooner. Some examples of problems which may arise in a portfolio that can be recognized early include excessive market risk relative to portfolio equity, inappropriate pricing of securities, increased volatility of performance, and style drift. Another advantage of risk monitoring is that the allocator may decide to hedge a portion of aggregate market exposure, using an overlay, during times of market trauma, or when there is an unanticipated concentration of risk in the aggregate portfolio. Finally, continuous monitoring of hedge fund portfolios and a deeper knowledge of hedge fund behavior helps the investor to make better allocation decisions at the point of manager selection. Careful due diligence prior to investing, and ongoing qualitative and quantitative monitoring through transparency and risk measurement analytics after investing provide powerful weapons to for successful hedge fund investing. These weapons can help stand the test of time through vast range of market climates and global events.  

August 2001 

Parker Global Strategies, LLC

Parker Global Strategies is a Manager-of-Managers providing a broad spectrum of Alternative Investment Strategies to private and institutional investors.