Hedge Fund Risk Management is “A Work in Progress”

By Simon Kerr

For a long period I was unable to carry on reading SEI’s fifth annual global survey of institutional hedge fund investors beyond this summary point: “RISK MANAGEMENT IS A WORK IN PROGRESS. Only one in five of those we polled agreed that “most hedge funds do a good job of risk management.” ” The view embedded is a strong challenge to the proposition offered by those who run hedge funds.

In concept hedge funds do what they are supposed to because the managers are able to turn a fecund source of alpha into an attractive return series through an appropriate risk management framework. It is feasible to have an outstanding insight into companies/stocks/markets that enables a manager to run with an okay risk framework to produce the required return, but is extremely unusual, and, from experience, cannot be relied on to grind out returns. Rather a good risk management approach and processes are sine qua non for a successful hedge fund.

So the respondents in the survey of 105 investors in hedge funds, across a range of investor types, conducted by SEI are perhaps able to distinguish between the typical and the best in this area. In answer to the question “Do hedge funds generally do a good job of risk management?” One in five said yes, 28% disagreed and the rest were not committed.

The endowments, pension plans, family offices and consultants that completed the survey may have had in mind that hedge funds have produced losses in two out of the last four years so the recent evidence is that the typical hedge fund does not do a good job in risk management if the point of the risk framework is to produce the target return of absolute performance. However only a very small minority of capital in hedge funds is invested in “the typical hedge fund”, that is through replication or hedge fund index products. Rather there is a research process and hedge funds are actively selected.

There are around ten thousand active hedge funds today. An institutional allocation to hedge  funds might consist of as few as six funds*, but will run via, say, three funds of funds plus a few individual selections to a maximum of 100 single manager hedge funds for a large pension plan. The survey question “Do hedge funds generally do a good job of risk management?” addresses the 10,000. What if the question had been “Do the hedge fund managers you selected and allocate capital to do a good job in risk management?” Would the response have been the same?  

* see earlier article on an institutional mandate