Institutional Investor Conference / November 17, 2004: Building an Effective Risk Management Strategy for Your Hedge Fund

Transcription

1 Institutional Investor Conference / November 17, 2004: Building an Effective Risk Management Strategy for Your Hedge Fund Ms. Hilary Till * Premia Risk Consultancy, Inc.* info@premiacap.com * Phone: * Chicago * Fax:

2 I. Should You Invest in Third-Party Risk Management Solutions or Build Them In-House? A prominent hedge fund manager, whose firm currently has $5 billion under management, stated in 1993: Other people have the same information as I do; other people put on the same trades on as I do. I make money; they don t. Proprietary investment strategies may not be the most important element of an investment process. Instead, how one implements a program s portfolio construction and risk management process may be what is most important. This means that for core strategies, which are key performance drivers for a fund, one should develop a proprietary (and therefore in-house) risk management program. 2

3 II. Are Quantitative Methods Sufficient for a Sound Risk Management Program? Necessary, but not sufficient. Also need a sound organizational structure Sound Practices for Hedge Fund Managers (2000, 2003) A blizzard of quantitative risk data will not help investors separate the good hedge funds from the bad. Instead, the best risk-related disclosures are ones that convey information about the practice of risk management within a fund. This information includes providing the resumes of the risk manager and his or her staff as well as the risk manager s position within the hedge fund organization. Source: Schachter, Barry, The Dilemmas of Risk Disclosure, Risk Magazine, September 2003, pp. S2-S5. 3

4 II. Quantitative Methods (Continued) One must also understand the economic basis of strategies. Another prominent hedge fund manager stated in 1998 that his prospective investors were only interested in receiving a one-page summary of his firm s performance numbers. It was if hedge fund investors were applying Baron von Bismarck s advice on sausages and legislation to their investments. ( Anyone who likes legislation or sausage should watch neither one being made, Bismarck was quoted as saying.) Source: Till, Hilary, Risk Measurement of Investments in the Satellite Ring of a Core-Satellite Portfolio: Traditional versus Alternative Approaches, Singapore Economic Review, April 2004, pp Weisman (2002) and Anson (2002) warn investors about investment strategies that require no investment skill and yet for long periods of time seem to provide superior returns. Sources: Anson, Mark, Symmetric Performance Measures and Asymmetrical Trading Strategies: A Cautionary Example, Journal of Alternative Investments, Summer 2002, pp Weisman, Andrew, Informationless Investing and Hedge Fund Measurement Bias, Journal of Portfolio Management, Summer 2002, pp

5 II. Quantitative Methods (Continued) Example of informationless strategy : Selling out-of-the-money puts and calls on the S&P 500 Source: Anson, Mark, Symmetric Performance Measures and Asymmetrical Trading Strategies: A Cautionary Example, Journal of Alternative Investments, Summer

6 II. Quantitative Methods (Continued) One must acknowledge the limits to (standard) quantitative techniques: without normality even trillions of parameters might not suffice to model the tail risks of different portfolios. Source: Osband, Kent, Iceberg Risk, Texere, New York,

7 III. Identifying Effective Tools for Evaluating, Measuring, and Monitoring Risk Quantitative methods are not sufficient, but they are necessary for a sound risk management program. A number of alternative investment strategies are essentially risk premia strategies. They earn returns because they are performing an economic function that involves some form of risk transfer or provision of liquidity. Source: Till, Hilary, Risk Considerations Unique to Hedge Funds, Quantitative Finance, December 2002, pp Examples across asset classes: fixed income arbitrage, event-driven equity strategies, weather fear premium trades in commodities, and currency carry trades. Sources: Till, Hilary, Life at Sharpe s End, Risk & Reward, September 2001, pp Till, Hilary, Measure for Measure, Risk & Reward, October 2001, pp Key active element for risk premia strategies: risk management, including hedging, leverage choice, and event-risk protection. 7

8 III. Effective Tools (Continued) VAR Parametric Historical Simulation (Everyone Understands It) Risk Budgeting Scenario Testing and Event Risk Protection Within Horizon Risk / Drawdown Estimation Extreme Risk Measures (CVar / MVar) for Portfolio Construction Minimizing Tail Losses But Time Window Dependent Source: Favre, Laurent, Does Extreme Risk Affect the Fund of Hedge Funds Weights?, UBS Wealth Management, Presentation at EDHEC Hedge Fund Day 2004, London, May

9 III. Effective Tools (Example) Scenario Testing and Event-Risk Protection Perform event-risk simulations on the portfolio and decide whether to buy macro portfolio protection against these events. Meaningful Eventful Periods October 1987 stock market crash Gulf War in 1990 Fall 1998 bond market debacle Aftermath of 9/11/01 attacks 9

10 III. Effective Tools (Example) Example Risk Reports by Theme in a Commodity Portfolio Worst-Case Loss Worst-Case Loss Strategy Value-At-Risk During Normal Times During Eventful Period Deferred Reverse Soybean Crush Spread 2.78% -1.09% -1.42% Long Deferred Natural Gas Outright 0.66% -0.18% -0.39% Short Deferred Wheat Spread 0.56% -0.80% -0.19% Long Deferred Gasoline Outright 2.16% -0.94% -0.95% Long Deferred Gasoline vs. Heating Oil Spread 2.15% -1.04% -2.22% Long Deferred Hog Spread 0.90% -1.21% -0.65% Portfolio 3.01% -2.05% -2.90% Incremental Contribution to Incremental Contribution to Strategy Portfolio Value-At-Risk* Worst-Case Portfolio Event Risk* Deferred Reverse Soybean Crush Spread 0.08% -0.24% Long Deferred Natural Gas Outright 0.17% 0.19% Short Deferred Wheat Spread 0.04% 0.02% Long Deferred Gasoline Outright 0.33% 0.81% Long Deferred Gasoline vs. Heating Oil Spread 0.93% 2.04% Long Deferred Hog Spread 0.07% -0.19% * A positive contribution means that the strategy adds to risk Source: Till, Hilary, Risk Management Lessons in Leveraged Commodity Futures Trading, Commodities Now, September 2002, pp

11 III. Effective Tools (Example) Within Horizon Risk / Drawdown Estimation Source: Mark Kritzman, Hidden Risks of Hedge Funds, and Asset Allocation versus Security Selection, Presentation to Boston QWAFAFEW, 2/12/02. 11

12 III. Effective Tools (Example) Extreme Risk Measures for Portfolio Construction The figure illustrates how the efficient frontier is affected when using modified VaR rather than VaR as the risk constraint when a portfolio includes hedge funds, some of which have asymmetric payoffs. Historische Historic monthly monatliche returns Renditen 0,90% 0,80% 0,70% 0,60% 0,50% 0,40% Effizienzlinie Efficient frontier ohne without Berücksichtigung consideration von of S S + + K K Effizienzlinie Efficient frontier mit with Berücksichtigung consideration von of S S + + K K 0,30% 1,00 2,00 3,00 4,00 5,00 6,00 Normale and und modified modifizierte VaR VaR (in %) (in %) Source: Signer, Andreas and Laurent Favre, The Difficulties of Measuring the Benefits of Hedge Funds, Journal of Alternative Investments, Summer