Hedge Fund Risk Fundamentals : Solving the Risk Management and Transparency Challenge

by HORWITZ RICHARD

• ISBN13: 9781576601631
• ISBN10: 1576601633
• Format: Hardcover
• Copyright: 2004-05-01
• Publisher: John Wiley & Sons Inc

Summary

Hedge Fund Risk Fundamentals is the first book to bring these issues to the forefront. With clarity, concision, and minimal math, Richard Horwitz lays out the key components and the cutting-edge processes in the field of hedge fund risk management today. Against that backdrop he presents a groundbreaking utility destined to set the standard for transparency and risk management within the hedge fund universe. You'll learn why, when it comes to risk management, 1 + 1 = 1.41. For all of those perplexed by the difficulties of assessing risk in hedge fund investing, Horwitz's concepts make for an invaluable road map and a demystifying resource that hedge funds and investors at all levels will find indispensable.

Author Biography

Richard Horwitz is senior vice president and director of risk management and performance analytics at Kenmar Global Investment Management Inc., a fund of hedge funds located in Greenwich, Connecticut.

Table of Contents

Acknowledgments	xiii
Foreword	xv
Preface	xix
INTRODUCTION	1	(10)
Part One The Components of Risk
1 VOLATILITY	11	(14)
Risks in Hedge Funds versus Traditional Investments	14	(7)
The Distribution of Hedge Fund Returns	21	(2)
Value at Risk (VaR)	23	(2)
2 DIVERSIFICATION	25	(12)
The Power of Diversification	26	(5)
Systematic Biases	31	(5)
Overdiversification	36	(1)
3 LEVERAGE	37	(10)
Financing Leverage	39	(5)
Borrowing Leverage	39	(1)
Notional Leverage	40	(4)
Unlevered Risk	44	(1)
Instrument Risk	44	(1)
Construction Leverage	44	(1)
What Is the Right Amount of Leverage?	45	(2)
4 ILLIQUIDITY	47	(12)
Planning in Case of Crisis	47	(2)
The Size Factor	49	(1)
Elements in an Escape Plan	49	(2)
The Cost of Illiquid Redemption Policies	51	(8)
Choosing among Alternatives	52	(1)
Calculating the Opportunity Cost of Illiquidity	52	(7)
Part Two Market Risk Management
5 MEASURING RISK	59	(12)
Sell-Side Heritage	59	(1)
Normal Market Behavior	60	(8)
Will History Repeat?	61	(2)
Risk Measures Based on Actual Fund Returns	63	(1)
Risk Measures Based on Simulated Fund Returns	64	(4)
Crisis Market Behavior	68	(3)
6 UNDERSTANDING THE SOURCE OF RISK	71	(12)
Slicing and Dicing or Bucketing	71	(1)
Index-Based Benchmarks	72	(1)
Value at Risk (VaR)	73	(1)
Risk Factor Framework	74	(5)
Marginal Risk Measures	79	(4)
7 RISK VISUALIZATION AND ARTICULATION	83	(8)
Comparative Statistics	83	(2)
Risk Visualization Techniques	85	(3)
Communicating Risk in "Hedge-Speak"	88	(3)
8 RISK CULTURE	91	(10)
Integrating Risk Management into All Hedge Fund Processes	92	(1)
Style Drift versus Nimbleness	93	(3)
Personality Risks	96	(5)
Status Issues	96	(1)
Environment Issues	96	(5)
Part Three Other Risk Processes
9 NON-MARKET RISK MANAGEMENT	101	(8)
Systems and Procedures	104	(1)
Organizational Issues	105	(2)
Disciplined Processes	107	(2)
10 CONSTRUCTING A FUND	109	(14)
Value Creation Levers	111	(2)
Shorting	113	(3)
Hedging	113	(1)
Overvalued Positions	113	(2)
Relative Misvaluations	115	(1)
Illiquid Securities	116	(1)
Leverage	117	(1)
Convexity	118	(1)
Nimbleness	119	(1)
Establishing a Basis in which to View the Construction	120	(1)
Balancing Risk and Return	121	(2)
11 PERFORMANCE ATTRIBUTION	123	(4)
Assessing Primary Sources of Returns	123	(2)
Other Factors in Performance Attribution	125	(2)
12 RISK BUDGETING	127	(16)
Risk Budgeting Self-Assessment	127	(1)
Definition of Risk Budgeting	128	(1)
Formal Risk Budgeting	128	(8)
A Management Process, Not a Back-Office Tool	129	(2)
A Common Language	131	(2)
Managing Complex Causal Relationships	133	(1)
A Comprehensive and Integrated Approach	134	(2)
Integrated Systems Support the Process	136	(1)
How Formal Should Your Risk Management Be?	136	(7)
Part Four Risk from the Investor's Viewpoint
13 NAV/RETURN REPORTING	143	(8)
Lack of Documentation	143	(3)
Inefficiencies	146	(1)
Incomplete Reporting	147	(1)
Lack of Precision	147	(2)
Misleading Measures	149	(1)
Masking Risk	150	(1)
Dressing Up Returns	150	(1)
14 CONSTRUCTING A PORTFOLIO OF FUNDS	151	(8)
Integrating Asset Allocation, Manager Selection, and Portfolio Construction	152	(7)
Understand Manager Risks	154	(1)
Understand Your Objective	154	(1)
Adopt a Prospective Outlook	155	(1)
Focus on Marginal Risk and Return Measures	155	(1)
Construct the Portfolio Incrementally	155	(1)
Minimize Exposure to the Underlying Market	156	(1)
Manage Secondary Risk Exposures	156	(1)
Maximize Idiosyncratic Risks	156	(1)
Limit Offsetting Exposures	157	(1)
Diversify the Portfolio	157	(1)
Plan for the Worst	158	(1)
Consider Using Optimizers	158	(1)
15 RISK DUE DILIGENCE	159	(8)
Analyzing Previous Portfolios	160	(2)
Determining Transparency and Risk Culture	162	(5)
16 TRANSPARENCY	167	(12)
Changing Investor Requirements	167	(3)
The Political Environment	170	(5)
The Pros and Cons of Position Disclosure	175	(1)
Current Practices	175	(4)
Part Five The Solution
17 INDUSTRY STANDARD SOLUTION	179	(6)
Reporting Standards-A Common language	181	(1)
The Case for Standardization	181	(4)
18 THE RISK FUNDAMENTALS' SOLUTION	185	(64)
Overview of the Service	185	(12)
NAV/Return Reporting	186	(1)
The Risk Fundamentals Ss stem	187	(1)
The Risk Fundamentals Statistics	188	(3)
Distributed Solution	191	(1)
Standardization with FiexibiIitv	192	(2)
Risk Budgeting Support	194	(1)
Effective Risk Communication	195	(2)
Interpreting Risk Management Reporting	197	(52)
Concentrations	199	(10)
Leverage	209	(2)
Liquidity	211	(6)
Risk Factors	217	(7)
Historical Simulation	224	(4)
Stress Tests	228	(2)
Convexity	230	(1)
Risk-Return Analyses	231	(1)
Constructing a Fund	232	(6)
Constructing a Portfolio of Funds	238	(6)
Performance Attribution	244	(5)
19 SUMMARY	249	(4)
APPENDIX	253	(8)
Glossary	261	(8)
Index	269