Hedge Fund Risk Fundamentals Solving the Risk Management and Transparency Challenge

by Horwitz, Richard; Koss, Ramon

• ISBN13: 9781576602577
• ISBN10: 1576602575
• Edition: 1st
• Format: Paperback
• Copyright: 2007-07-01
• Publisher: Bloomberg Press

Summary

In the constantly evolving hedge fund marketplace, nothing is more central but in many ways, more elusive than risk. Yet there remains no standard for analysing and measuring risk within this highly secretive, largely unregulated field, leaving the thousands of hedge funds, and the tens of thousands of hedge fund investors, in dangerously dim light. The industry has not solved the "transparency" challenge of communicating risk to investors without disclosing proprietary information. Hedge Fund Risk Fundamentalshighlights these issues clearly and concisely as the author, Richard Horwitz, lays out the key components and the cutting-edge processes in the field of hedge fund risk management. This book presents a groundbreaking resource destined to set the standard for transparency in risk management within the hedge fund universe.

Author Biography

Richard Horwitz is managing director of manager assessment and risk management of Merrill Lynch's Hedge Fund Development and Management Group (HFDMG). He has implemented Risk Fundamentals, a proprietary risk transparency and management system. The system is risk factor based, permitting underlying funds to provide structural risk transparency without requiring position disclosure and for this transparency to be used to provide a fundamental understanding of each underlying fund and to construct risk-efficient portfolios of funds. Previously, Horwitz was senior vice president and director of risk management and investment analytics at Kenmar Global Investment Management Inc., a $2 billion fund of funds. He gained his fundamental knowledge of hedge funds as a principal at Capital Market Risk Advisors, Inc., the boutique risk management consulting firm. Horwitz had previously been a buy-side senior equity analyst at Sanford C. Bernstein & Co. and a consultant in financial services at Booz Allen Hamilton Inc. He earned an MS in management (Sloan School) and a BS in electrical engineering from the Massachusetts Institute of Technology. Horwitz has also written numerous articles on hedge funds.

Table of Contents

Foreword

Preface

Introduction

The Components of Risk

Volatility Risks in Hedge Funds versus Traditional Investments

The Distribution of Hedge Fund Returns Value at Risk (VAR)

Diversification The Power of Diversification Systematic Biases Overdiversification

Leverage Financing

Leverage Borrowing

Leverage Notional

Leverage Unlevered Risk

Instrument Risk

Construction Leverage

What Is the Right Amount of Leverage?

Illiquidity Planning in Case of Crisis

The Size Factor Elements in an Escape Plan

The Cost of Illiquid Redemption Policies Choosing among Alternatives

Calculating the Opportunity Cost of Illiquidity

Market Risk Management

Measuring Risk Sell-Side Heritage Normal Market Behavior Will History Repeat?

Risk Measures Based on Actual Fund Returns Risk Measures Based on Simulated Fund Returns Crisis Market Behavior

Understanding the Source of Risk Slicing and Dicing or Bucketing Index-Based Benchmarks Value at Risk (VaR)

Risk-Factor Framework Marginal Risk Measures

Risk Visualization and Articulation Comparative Statistics Risk Visualization Techniques Communicating Risk in "Hedge-Speak"

Risk Culture Integrating Risk Management into All Hedge Fund Processes Style Drift versus Nimbleness Personality Risks Status Issues Environment Issues

Other Risk Processes

Non-Market Risk Management Systems and Procedures Organizational Issues Disciplined Processes

Constructing a Fund Value Creation Levers Shorting Hedging Overvalued Positions

Relative Misvaluations Illiquid Securities Leverage Convexity Nimbleness Establishing a Basis in which to View the Construction Balancing Risk and Return

Performance Attribution Assessing Primary Sources of Returns Other Factors in Performance Attribution

Risk Budgeting

Risk Budgeting Self-Assessment Definition of Risk Budgeting

Formal Risk Budgeting A Management Process, Not a Back-Office Tool

A Common Language Managing Complex Causal Relationships

A Comprehensive and Integrated Approach Integrated Systems Support the Process

How Formal Should Your Risk Management Be?

Risk from the Investor's Viewpoint

NAV/Return Reporting Lack of Documentation Inefficiencies Incomplete

Reporting Lack of Precision Misleading Measures Masking Risk Dressing Up Returns

Constructing a Portfolio of Funds Integrating Asset Allocation, Manager Selection, and Portfolio Construction

Understand Manager Risks

Understand Your Objective

Adopt a Prospective Outlook Focus on Marginal Risk and Return Measures

Construct the Portfolio Incrementally Minimize Exposure to the Underlying Market Manage

Secondary Risk Exposures Maximize Idiosyncratic Risks Limit Offsetting Exposures

Diversify the Portfolio Plan for the Worst Consider Using Optimizers

Risk Due Diligence Analyzing Previous Portfolios Determining Transparency and Risk

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