Risk Measurement Providers
http://www.fenews.com/fen46/front-sr/jorion/jorion.html
The first hedge fund was started by A.W. Jones in 1949. Unlike the typical equitymutual fund, the fund took both long and short positions in equities. Since then, the hedge fund industry has undergone exponential growth. Today, there are more than 8,000 hedge fund managers with close to $1 trillion in investor equity.
This growth has led to concerns about the industry. In particular, investors should be concerned about risk management practices, liquidity and transparency of their hedge funds. This short article discusses whether these concerns are warranted and what steps hedge funds could take to be accepted as mainstream investment vehicles.
Hedge funds are private investment vehicles that are generally leveraged. As an industry, however, they are very heterogeneous. Hedge fund strategies include long/short equity, global macros, equity market neutral, fixed-income arbitrage, convertible arbitrage, event driven and managed futures. Some hedge fund categories, such as those that invest in futures contracts, have little liquidity risk and are amenable to traditional risk measurement methods. Others, however, are exposed to liquidity risk, which needs special attention.
Liquidity Risk
Liquidity risk arises on the assets side, when the positions cannot be liquidated quickly without incurring transaction costs. It also arises on the liabilities side, either from the leverage (debt), or from potential investor redemptions (equity). Typically, funds with greater asset liquidity risk impose longer lockup periods for investors in order to balance liquidity risk on both sides of their balance sheet.
On the asset side, liquidity risk is a function of the size of the positions as well as of the price impact of a given size trade for the instrument. Some categories of hedge funds have intrinsic liquidity risk because the instruments they use are thinly traded, implying a large price impact for most trades. This is the case with convertible bonds or distressed securities. In this case, liquidity risk arises even for small funds. Liquidity risk, however, is also an issue when the fund positions grow very large, even in liquid markets.
Liquidity risk is difficult to factor into the usual value-at-risk (VAR) models. Usually, VAR models loosely account for liquidity risk by extending the horizon for less liquid assets. This is a totally ad hoc approach, however. Accounting for potential losses due to asset liquidation requires a price impact function, which is difficult to estimate. Optimal liquidation strategies should balance the direct cost of fast liquidation against the risk of keeping open positions.
Liquidity and Valuation
Instrument liquidity risk creates another problem which is that of stale prices. Say that the reporting period for net asset values (NAV) is the end of each month. If transaction prices are not observed at the end of the month, the valuation may be using a price from a trade that occurred in the middle of the month, creating measurement errors in the reported NAVs. This is a minor nuisance, but does not necessarily create a systematic bias in the NAVs. Investors, however, should make sure the hedge fund manager is not manipulating asset values to overstate the fund’s performance.
Liquidity and Risk Measures
Unfortunately, stale prices do bias risk measures in a number of subtle ways. First, the reported monthly volatility will be less than the true volatility. This is because prices are based on trades during the month, which is similar to an averaging process. Averages are less volatile than end-of-period values.
The second effect is that monthly changes will display positive autocorrelation. A movement in one direction will only be partially captured using prices measured during the month. The following month, part of the same movement will show up in the return. This positive autocorrelation substantially increases the risk over longer horizons and invalidates the usual square root of time rule, which is widely used to extrapolate risk to longer horizons.
A third, related effect is that measures of systematic risk will be systematically biased downward. If the market goes up during a month, only a fraction of this increase will be reflected in the NAV, leading to beta measures that are too low. Thus the diversification benefits of the hedge fund may be overstated.
Transparency
Because hedge funds follow proprietary trading strategies, they are generally reluctant to reveal information about their trading ideas or positions. This lack of transparency has serious disadvantages for investors.
Disclosure allows risk monitoring of the hedge fund, which is especially useful with active trading. This can help to avoid situations where the hedge fund manager unexpectedly increases leverage or changes style. Closer monitoring of the fund can also decrease the probability of fraud.
Disclosure is also important for risk aggregation. The investor should know how the hedge fund interacts with other assets in the investor’s total portfolio. Whether the hedge fund has a positive or negative correlation with the rest of the portfolio will have an effect on the total risk.
Greater disclosure is often resisted on the grounds that it would disclose proprietary information, leading to the possibility of a third party trading against the hedge fund. Another argument sometimes advanced is the lack of investor sophistication. In other words, disclosing positions would dump too much information on investors who might not able to use it. Indeed, a simple listing of the positions would provide limited information in the absence of a rationale for the trading strategy.
These two arguments can be addressed with external risk measurement providers. These firms have access to the individual positions of hedge funds, with the proper confidentiality agreements, and provide aggregate risk measures to investors. They only release exposures to major risk factors, such as net duration, net systematic risk and so on. This solution neatly solves the problems of risk aggregation and managers’ widespread reluctance to disclose detailed information about their positions.
Another solution is the fund-of-fund structure. These are diversified portfolios of hedge funds, which try to achieve diversification by careful selection of styles and managers. Funds of funds can also take views on strategies, increasing allocation to strategies that are expected to perform better. Many of these funds of funds have developed advanced methods to measure their total portfolio risk based on the complete positions of the hedge funds to which they allocate assets.
Conclusions
Continued growth of the hedge fund industry is only sustainable if these issues of liquidity and transparency are addressed in one way or another. Investors should be aware that liquidity risk may be important for some categories of hedge funds and may lead to biases in risk measures. Several methods can be used to correct for these biases. Finally, the development of risk measurement providers and funds of funds demonstrates the importance of transparency for hedge funds.