The Big Pay Off: Why Hedge Funds Can't Afford to Ignore Risk Exposure: Knowledge@Wharton

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The Big Pay Off: Why Hedge Funds Can't Afford to Ignore Risk Exposure
Published : December 08, 2010 in Knowledge@Wharton

To outsiders, the hedge fund industry often looks like the Wild West. For
these lightly regulated and secretive investment pools, restricted to
institutions and the wealthy, anything goes: exotic "black box" strategies,
bets on portfolios packed with seemingly unrelated holdings, heavy
borrowing to magnify results....
But hedge funds aren't betting the farm on a roll of the dice. In fact, many
hedge fund managers spend considerable time and money trying to insure
that the potential gains from any investment strategy will be worth the risks.
How well does risk management work? Because hedge funds are so
secretive, that hasn't always been easy to figure out. "It's very hard to
understand empirically what the benefit of risk management is," says
Wharton accounting professor Gavin Cassar. "Most of the time you cannot
observe what an organization's risk practice is." This is a single/personal use copy of
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not a given, either. Hedging and other strategies can be expensive, and too x407.

much caution can stunt profits. "It's not obvious that by having better risk
management, you are going to be a better-performing fund," Cassar notes.
To explore these issues, Cassar and Joseph Gerakos, accounting professor at the University of Chicago's
Booth School of Business, looked at the risk management practices of 114 funds with $48 billion under
management, assessing how the funds performed between January 2007 and December 2008. The
research showed that certain types of funds are more likely to use risk management than others, that some
risk management practices work better than others, and that the benefits can indeed outweigh the costs.
Funds that used the most effective types of risk management practices dramatically outperformed the
others during the financial market meltdown from September to November 2008. During that October, for
example, funds that used at least one type of formal model to evaluate portfolio risk lost 3.5% while those
that used none lost 9.3%. "Funds in our sample that use formal models performed better in the extreme
down months of 2008 and, in general, had lower exposures to systemic risk," Cassar and Gerakos write in
their paper, " How Do Hedge Funds Manage Portfolio Risk?"
'Left-tail Risk'
Because the future is unknown, all investors take risks, no matter how simple and "safe" their strategy
appears. Even an investor who puts everything into government-insured bank deposits could be a loser if
interest earnings fell behind the inflation rate, or if other investments did much better.
One of the standard risk gauges is volatility, or the tendency of a single security, commodity, currency or
derivative to move up and down in price. The odds of a gain or loss and its magnitude are often inferred
by looking at past performance, and volatility can be calculated for whole categories of investments, such
as the 500 stocks in the Standard & Poor's 500. Money managers and investment institutions, says Cassar,
are especially concerned with "left-tail risk." Left tail events are those that are considered very unlikely
but very damaging.
With a single investment, controlling risk can be more straightforward. If the investor owned shares of
Google, for example, the risk of loss could be offset by purchasing put options guaranteeing the shares
could be sold at a minimum price. The cost of the options and the likelihood of a price decline would

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The Big Pay Off: Why Hedge Funds Can't Afford to Ignore Risk Exposure: Knowledge@Wharton
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determine whether this was worthwhile. But risk management becomes far more complex when the
investor, such as a hedge fund manager, has a variety of bets at the same time. Not only must the manager
look at the odds of a gain or loss of each holding, he must figure how a combination of market conditions
will affect the portfolio as a whole.
What if stock prices rise, a given currency falls, inflation drops, interest rates nudge up and oil becomes
more expensive? Parts of the portfolio may rise while others would probably fall, but would the gains
outweigh the losses? How should the holdings be adjusted as conditions change? How much should the
fund be willing to spend to minimize the effects of a very rare combination of factors?
"When you have a portfolio that changes, not only do you have to understand how individual assets or
investments change with states of the world, you have to understand how these different assets in your
portfolio co-vary," says Cassar, referring to how different assets behave during the same period.
Strategies for managing risk have evolved over time, he adds. The greater availability of market data and
growing computer power are factors, but managers are also more willing to spend time and money
assessing risk when risks appear to be bigger. "Obviously, when the market is going up, people pay less
attention to their risk exposure," Cassar notes, comparing investors to computer users who pay less
attention to backing up data until their machines crash.
Unlike plain vanilla investment pools such as mutual funds, hedge funds are allowed to take
extraordinary risks. Only wealthy individuals and institutions are allowed to invest in them, and often
they are given only the most general description of how the fund will use their money. Hedge fund
investors typically commit their money for a number of years, and they pay relatively high fees -- 2% of
assets per year plus 20% of profits. The fund may also borrow money so it can place bets many times
larger than it would by using only the investor's contributions. If a fund invests $10 for every $1 collected
from investors, it could double investors' money with a 10% return on the portfolio -- or wipe investors
out with a 10% loss.
Because of the risks, high fees and restrictions, hedge fund investors expect to do much better than they
would by simply investing in the broad market -- with a mutual fund holding S&P 500 stocks, for
instance. Hedge fund managers therefore have an incentive to take big risks.
Hedge funds commonly tell investors they have risk management strategies in place, but they generally
don't provide many details. "It's very easy for a fund to say, yes, we think risk management is important,"
says Cassar. "That's lip service."
To find out what practices the funds actually use, Cassar and Gerakos used data collected by The Hedge
Fund Due Diligence Group at Analytical Research, a firm that interviews hedge fund managers about
their operations and risk management so it can advise individuals and institutions considering hedge fund
investments. The firm determines whether a fund uses formal risk assessment measures such as
Value-at-Risk, stress testing and scenario analysis, and it determines whether the fund has a dedicated
risk officer and rules on how much of its portfolio can be concentrated in individual holdings, which is
riskier than spreading money around.
For some funds, the firm's data includes reports on how managers interviewed prior to 2008 expected
their funds to perform in extreme conditions like a bear market in stocks -- conditions that did strike in the
fall of 2008 amidst the financial crisis.
The Analytical Research data revealed that "some hedge funds devote significant attention to portfolio
risk management practices," Cassar and Gerakos write. "Specifically," they add, "levered funds are more
likely to use formal models of portfolio risk, funds that hold large numbers of positions are more likely to
have dedicated risk officers with no trading authority, and funds that hold positions for longer durations
are less likely to have position limits."
Risk officers who also trade have a conflict between minimizing risks and taking them, so a firm that bars
its risk expert from trading has a stronger commitment to controlling risks. The study showed funds were
more likely to have dedicated risk officers, or ones with no trading authority, if the fund's managers
invested a lot of their own money in the fund. Funds that hold positions for longer periods have less need
for risk management strategies.

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The Big Pay Off: Why Hedge Funds Can't Afford to Ignore Risk Exposure: Knowledge@Wharton
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Some risk management techniques did prove valuable during the worst of the financial crisis, Cassar and
Gerakos report. "Examining performance during the equity bear market that occurred from September
through November 2008, we find that managers of funds that use Value-at-Risk and stress testing to
evaluate portfolio risk had more accurate expectations about how their fund would perform during this
period," Cassar and Gerakos write. "In contrast, we find no association between the accuracy of
expectations and the other risk management practices."
Value-at-Risk is a statistical tool that indicates the probability that a portfolio's value will fall by a given
percentage during a day, a week or some other period. Stress testing assesses how the portfolio would
perform under a variety of market conditions.
Benefits of Formal Models
Finally, the two researchers found that funds that used formal models for assessing risk "did relatively
better in the extreme down months of 2008 than those that did not." In fact, the improved performance
was dramatic: Funds using formal models beat funds that did not by about six percentage points. "Overall,
our results suggest that models of portfolio risk increase the accuracy of manager's expectations and assist
managers in reducing exposures to both downside and portfolio risk," they write.
"We find that the funds that did these particular activities had more accurate expectations about how they
would perform during an equity crisis," Cassar says.
While fund managers want to minimize losses in down markets, they do not want to impose risk controls
that crimp gains in up markets. That would happen if hedging and other strategies were too costly, or if
the fund became too conservative to make bets that could produce big returns. According to Cassar, more
work needs to be done on this question but "the evidence is not very strong to [say] that during good
periods, risk management is a retardant to performance."
With hindsight, most experts agree that hedge funds were not a factor in the most recent financial crisis,
but because the funds' practices are so opaque, some worry about whether they could foment
market-wide trouble in the future.
While the work by Cassar and Gerakos does not indicate how much systemic risk the hedge fund industry
could create, Cassar says it does show that risk management is more common than many experts had
thought, and that risk management practices tend to steer managers away from the kinds of investment
portfolios that suffered heavily during the recent financial crisis.

This is a single/personal use copy of Knowledge@Wharton. For multiple copies, custom reprints, e-prints, posters or plaques, please contact
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