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 This vision is not too far away, and is in fact becoming even more likely thanks to forthcoming legislation such as MiFID in Europe and CP176 from the UK’s Financial Services Authority that relates to soft commissions and bundled brokerage.

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Tools of the trade

In these times of increasing automation and regulation, how can an honest broker-dealer make a dollar or euro? Some would consider chucking it in and keeping it simple, whilst others are moving towards complexity. Which trading options will work and how do you play the markets for advantage in the future? Chris Skinner takes a look.The issue these days is that there are few market areas where you can really buck the system. By ‘buck the system’, I mean find alternative trading strategies to really gain competitive advantage. The last real move in this direction was the creation of the credit derivatives market ten years ago by JPMorgan. Credit derivatives are now a $12 trillion market - about the size of America’s annual GDP - but even that is becoming a commodity.

There appear to be three profitable directions for trading strategies in the future. The first is to create much more complex trading strategies using technology tools to win. The second is to create much more complex products using technology tools to win. The third is to move towards simplicity and outsource the trading operation to those who can afford the complex technological capabilities to manage this on your behalf. All three rely on technology tools to win.

These strategies are not mutually exclusive but can be mutually inclusive, depending on your overall market objectives. Let’s look at what each of these strategies mean in practice.

The first focuses upon creating much more complex trading systems using algorithmic trading. Algorithmic trading has historically been the domain of engineers and scientists. By way of example, of the key players involved in creating the credit derivatives markets, most were either science or mathematics graduates. In the words of the leader of the JPMorgan credit derivatives team at the time: “I wanted to be a rocket scientist and ended up working on Wall Street”. Actually, the real leader of the team - Peter Hancock now of Integrated Finance Ltd - was a science student at Oxford University who wanted to be an inventor…you get the drift.

These rocket scientists started the market towards more automated trading back in the late 1990’s using quantitative trading strategies and highly automated systems. This market began simplistically with buy-side hedge funds and sell-side brokers looking to find arbitrage and other complex plays in the equities and FX markets. For example, the original tools would have allowed an investor to find micro-opportunities in real-time and make trading wins of a reasonable size. For example, if the value of Microsoft (MFT) shares increase by more than 0.5% and the value of IBM (IBM) shares decrease by more than 0.5% at the same time, then buy MFT and sell IBM.

Today, the tools are being used more and more to create cross-asset class plays in all markets and are getting really clever. For example, if the value of MFT increase by more than 0.5% within a 30-minute window during which IBM shares decrease by more than 0.5%, then buy MFT and sell IBM whilst taking a futures option on IBM purchase and MFT sale for one month. In addition, if Oracle shares rise whilst SAP fall during the same 30-minute window, follow with Oracle buy and SAP sell with a hedged futures option. Finally, if these movements occur after a 3 point rise in the Nasdaq, then shift FX strategy from euro to US Dollars, with a sales option on the dollar.

In fact, you could add as many parameters as you wanted until you were happy you had played all the different criteria that might be required during that period. But it doesn’t end there.

I was at a recent conference where one key algorithmic firm discussed two new concepts of algo trading using the concepts of ‘TiVo playback’ and ‘graphic equalisers’. What they were getting at is the idea of placing all your complicated ideas and strategies for trading into the system, and then seeing how they would have played out over the past 30-day trading cycle. To do this, the system stores all the trade and market data for the last month and then allows you to fast forward, reverse, pause and stop the market activities during that cycle in a style similar to using a TiVo or Sky+ player.

Now the incredibly clever bit. Whilst you are playing your TiVo market simulations, you can see what works and does not work as a trading strategy through a sort of graphic equaliser. The system, in other words, shows you green for good stuff and red for bad.

The more you find trading strategies that work, the more you store those in the good stuff and they become inbuilt into the software algorithms. Equally, if your strategies didn’t work, you highlight those and that also becomes inbuilt into the software algorithms as the bad stuff. The result is that the software learns what works and doesn’t work and builds that into future trading patterns.

The impact of this is that it provides asset managers the ability to test strategies and moves their trading advice away from their brokers and onto their systems. So, you may well ask, what’s the point of active trading when the software tools are getting so good that they will ultimately always know the best trades to make with perfect timing?

In other words, if we create a ‘perfect’ market where all trading is so sophisticated using algo tools that you can only keep up if you use algorithmic trading, then those without algo tools are dead meat.

Well, not necessarily. And this leads to the second phase of market development which, as mentioned, is complementary to algorithmic trading.

If everyone has algo tools that learn trading strategies and always strike perfect trades with perfect timing, then those in the human world have to go and find something else to do, such as more complex credit derivatives.

When the JPMorgan team created credit derivatives in the late 1990’s, they were looking for a way to create something that would be hard to copy. A bit like swaps, arbitrage and other futures and options, it was really a way to find another market.

Sounds easy, but if it was then every bank’s investment team would be winners. What the JPMorgan team succeeded in doing is creating something that was hard to copy because, by the time others knew what it was, they had taken the lion’s share of the market.

By way of a brief explanation. The way credit derivatives work is like an insurance policy for a bank’s credit risk. For example, the bank takes a basket of loans that mix $1 billion to Panama, $5 billion to Mexico and $2.5 billion to Columbia, and then offers the option on these loans defaulting as a credit derivative. The investor only has to pay on the derivative if the borrowers default. Meanwhile, if the loans are paid off, then the investor has made a packet of cash from the premiums the banks pays to offset their credit risk.

This has contributed to an acceleration in lending, and rising exposures. For example, of General Motors’ stated losses of over $10 billion last year, over $2 billion were hidden in the finance arm GMAC as a result of an exposure to over $200 billion in credit derivatives. Similarly, in March 2006, Austria’s Bawag Bank announced that it had used offshore companies to mask almost €1 billion of losses for similar investments that almost turned the bank insolvent in 2000.

Even with such risks, banks love credit derivatives because it takes possibilities of substantial loan losses off their balance sheet and onto someone else’s, such as General Motors. That is why it is a market that has ballooned over the past decade from nothing to $12 trillion - bigger than the USA’s GDP - but is also now a market that has commoditised.

Like any great trading initiative - swaps, structured finance, arbitrage - the more popular the initiative, the more money it makes, the more others want to get in on the action, the more competitors start to buy the people who make the money, the more commoditised the market becomes. After ten years, credit derivatives are reaching market maturity and so the next big play is now being looked for. That big play is likely to be around complex cross-asset class trading strategies that combine equities, bonds, options, derivatives and FX.

There are huge dangers in this of course, and successful execution demands deep technological know-how. However, the only way in which markets can operate is to seek out and trade off risks against rewards, and the greater the risks, the greater the rewards.

Perhaps the approach is best summed up from a line out of Michael Lewis’s book Liar’s Poker, which described life in Salomon Brothers in the late 1980’s. In the book, Salomon’s head of law, Donald Feuerstein, took great delight in finding ‘chinks in the regulator’s armour’ which he could use in ways to buck the markets and make greater returns. In other words, the more markets are commoditised and regulated, the more complex and sophisticated the products and strategies which need to be used to generate returns. In today’s world of turbo-charged algorithmic cross-asset class trading strategies, that can only be delivered through massive investments in systems.

Which brings us to our third strategy.

The technological turbo-charging of the investment markets has meant that you have to have a huge cheque book and pen to be a player these days. Those firms that cannot aford to enter the game as a player in their own right will end up giving their trading to a third party to manage. After all, if you can outsource your customer service centre to Mumbai, why not do the same with your investment banking division if you can’t afford to be a top player?

Therefore, there will be a range of firms who find algo trading and derivatives beyond their reach. These firms will ditch their trading desks and get someone else to do it for them. By way of example, Acme Trading Desk Services Ltd offers outsourced trading desk facilities and soon finds that Acme supports Hedge Fund A on a Monday, Fund Manager B on a Tuesday, Investment Manager C on a Wednesday, Insurance Group D on a Thursday and maybe takes Friday off because the systems need a bit of an overhaul.

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 This vision is not too far away, and is in fact becoming even more likely thanks to forthcoming legislation such as MiFID in Europe and CP176 from the UK’s Financial Services Authority that relates to soft commissions and bundled brokerage.

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The combination of regulatory drivers, technology chargers and market makers’ margins, will deliver a future world in financial trading that will only be played by those who have the depth of pocket and technological know-how to be a player.

Chris Skinner is a director of TowerGroup and founder of Balatro.

Web links: www.towergroup.com and www.balatroltd.com

Author’s email: Chris Skinner

http://www.finextra.com/fullfeature.asp?id=743

http://www.fenews.com/fen17/hedge.html 

Hedge Fund Survey Overview

By Richard HorwitzCapital Market Risk Advisors, a financial advisory firm specializing in risk management, released the results of a recent survey on hedge funds as risk management. Hedge Fund Types Surveyed Participants include: Fund of Funds, Managed Futures, Risk Arbitrage, Long/ Short and Macro.

Approaches to risk management varied by hedge fund types.

Assets Under Management

Most respondents manage less than $500 million in onshore as well as offshore funds. No respondents manage more than $1 billion in offshore funds.

Assets by Class

The majority of respondents hold equity assets, with 70% holding international equity and 61% holding domestic assets.
Approximately 43% hold domestic fixed income assets and 33% hold international debt assets. Convertibles and distressed debt are held by approximately 15% of respondents.

Approximately 60% of respondents reported holding FX overlays.

Risk Management

Approximately 75% of respondents have a risk manager, though those that do not are not planning on adding a risk manager.

All respondents by the end of this year will have formalized their “risk appetite”.

An overwhelming majority of respondents have implemented a set of risk limits.

Risk Adjusted Performance

The majority of respondents measure risk-adjusted performance on an absolute basis. Those who do not measure risk adjusted performance generally do not plan to change.

Less than 50% of respondents measure risk-adjusted performance on a relative basis.

Sharpe and Sortino Ratios are the most widely used tools for measuring risk-adjusted performance.

Calculating / Measuring VaR

Approximately 70% of respondents will calculate VaR on an absolute basis by the end of this year.

However, only 13% of respondents calculated VaR on a relative basis.

The Variance/Covariance and Historical (Delta/Gamma) methods are the most widely used methods for calculating VaR.

Respondents applied differing holding periods to calculate VaR. Daily and monthly were the two most frequently selected.

Stress Testing

Scenario Analysis (actual scenarios such as the Russia/LTCM crisis and the Tequilla crisis) and Volatility Shifts are the two most widely used stress testing techniques.

Respondents are split on the frequency of stress-testing, though the majority stress test at least weekly.

Measuring Liquidity Risk

More than 80% of respondents measure liquidity — split relatively evenly among those that do it formally, those that do it informally and those that employ a hybrid of formal and informal means.

Informal measurement of liquidity risk is practiced at slightly higher levels than explicit measurement.

Whereas over 60% measure liquidity risk in terms of reduced volume on an informal basis, less than 40% do so on an explicit basis.

The majority of respondents will be aware of the dealers’ haircut methodologies by the end of the year.

Most respondents do not use and do not plan to use liquidity insurance.

Investors’ Interest in Risk Measures

Risk ratios are the most commonly reported risk statistic to investors, followed by leverage. VaR is currently only reported by 26% of respondents.

The majority of respondents have not increased their risk reporting since the LTCM crisis. The biggest increase has been in VaR and Risk Adjusted Performance.

Approximately 30% of respondents said that investors were asking for increased reporting on concentration measures.

Approximately 20% to 30% of respondents said that investors were requesting increased reporting on liquidity.

More than a third of respondents stated that investors have increased their demand for position-level information.

Richard Horwitz is a Vice President at Capital Market Risk Advisors, Inc., a consulting firm headquartered in New York that specializes in risk management, valuation, strategy, and independent risk oversight. Horwitz received his undergraduate degree in Electrical Engineering from MIT and his MBA from the Sloan School of Management at MIT.

 http://www.federalreserve.gov/boarddocs/speeches/2006/200605162/default.htm

Remarks by Chairman Ben S. Bernanke
At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia
May 16, 2006

Hedge Funds and Systemic Risk

Thank you for inviting me to speak today. In keeping with the theme of this conference, I will offer some thoughts on the systemic risk implications of the rapid growth of the hedge fund industry and on ways that policymakers might respond to those risks.

The collapse of Long-Term Capital Management (LTCM) in 1998 precipitated the first in-depth assessment by policymakers of the potential systemic risks posed by the burgeoning hedge fund industry. The President’s Working Group on Financial Markets, which includes the Federal Reserve, considered the policy issues raised by that event and, in 1999, issued its report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. The years since then have offered an opportunity to consider whether the Working Group’s recommendations for addressing those issues have been effective and whether new concerns have arisen that warrant an alternative approach.

LTCM and the Working Group’s Recommendations
As the title of the report indicated, the Working Group focused on the potential for leverage to create systemic risk in financial markets. The concern arises because, all else being equal, highly leveraged investors are more vulnerable to market shocks. If leveraged investors default while holding positions that are large relative to the markets in which they have invested, the forced liquidation of those positions, possibly at fire-sale prices, could cause heavy losses to counterparties. These direct losses are of concern, of course, particularly if they lead to further defaults or threaten systemically important institutions; but, in addition, market participants that were not creditors or counterparties of the defaulting firm might be affected indirectly through asset price adjustments, liquidity strains, and increased market uncertainty.

The primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors. In the LTCM episode, unfortunately, market discipline broke down. LTCM received generous terms from the banks and broker-dealers that provided credit and served as counterparties, even though LTCM took exceptional risks. Investors, perhaps awed by the reputations of LTCM’s principals, did not ask sufficiently tough questions about the risks that were being taken to generate the high returns. Together with the admittedly extraordinary market conditions of August 1998, these risk-management lapses were an important source of the LTCM crisis.

The Working Group’s central policy recommendation was that regulators and supervisors should foster an environment in which market discipline–in particular, counterparty risk management–constrains excessive leverage and risk-taking. Effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients’ risk profiles and that they have systems to monitor and limit exposures to levels commensurate with each client’s riskiness and creditworthiness. Placing the onus on market participants to provide discipline makes good economic sense; private agents generally have strong incentives to monitor counterparties as well as the best access to the information needed to do so effectively.

For various reasons, however, creditors may not fully internalize the costs of systemic financial problems; and time and competition may dull memory and undermine risk-management discipline. The Working Group concluded, accordingly, that supervisors and regulators should ensure that banks and broker-dealers implement the systems and policies necessary to strengthen and maintain market discipline, making several specific recommendations to that effect. The Working Group’s recommendations on this point have largely been followed. Domestically, regulatory authorities issued guidance on risk-management practices, and bank supervisors now actively monitor and conduct targeted reviews of banks’ dealings with hedge funds. The Securities and Exchange Commission (SEC) intensified its risk-management inspections of the larger broker-dealers after LTCM. Internationally, both the Basel Committee on Banking Supervision and the International Organization of Securities Commissions produced papers on sound practices in dealings with highly leveraged institutions, and the Basel Committee conducted a series of follow-up studies.

An alternative policy response that the Working Group considered, but did not recommend, was direct regulation of hedge funds. Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds’ risk-taking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds’ ability to provide market liquidity.

In focusing on counterparty risk management in its recommendations, the Working Group did not intend to prevent failures in the hedge fund industry. Hedge funds offer their investors high prospective returns but also high levels of risk. Experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy. The Working Group’s recommendations were aimed, instead, at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.

Effectiveness of the Working Group’s Approach
Has the approach proposed by the President’s Working Group worked? Any answer must be provisional, but, to date, it apparently has been effective. Since the LTCM crisis, ongoing improvements in counterparty risk management and the resultant strengthening of market discipline appear to have limited hedge fund leverage and improved the ability of banks and broker-dealers to monitor risk, despite the rapidly increasing size, diversity, and complexity of the hedge fund industry. Many hedge funds have been liquidated, and investors have suffered losses, but creditors and counterparties have, for the most part, not taken losses. The general perception among market participants is that hedge funds are less highly leveraged today than in 1998 though, to be sure, meaningful and consistent measurements of leverage are not easy to come by and many newer financial products embed significant leverage in relatively nontransparent ways.

According to bank supervisors and most market participants, counterparty risk management has improved significantly since 1998. Some of this progress is due to industry-led efforts, such as two reports by the Counterparty Risk Management Policy Group (CRMPG) that lay out principles that institutions should use in measuring, monitoring, and managing risk. Reviews conducted by bank supervisors in 2004 and 2005 indicated that banks have become more diligent in their dealings with hedge funds. In most cases, substantial resources have been devoted to expanding and improving the staffing of the risk-management functions related to hedge fund counterparties. Dealers universally require hedge funds to post collateral to cover current credit exposures and, with some exceptions, require additional collateral, or initial margin, to cover potential exposures that could arise if markets moved sharply. Now, risk managers can more accurately measure their current and projected exposures to hedge fund counterparties, and more firms use stress-testing methodologies to assess the sensitivity of their exposures to individual counterparties if the market moves substantially.

Despite this progress, some concerns about counterparty risk management remain and may have become even more pronounced given the increasing complexity of financial products. I will note four of these concerns. First, hedge funds are profitable customers for dealers, and our supervisors are concerned that competition for hedge fund business has eroded initial margin levels. Second, given the increasing volume of complex transactions with hedge funds, we are also concerned whether counterparty exposures in such complex transactions are being measured accurately. Supervisors are monitoring banks with these issues in mind. Third, our supervisors are concerned that more extensive stress-testing should be done. Although stress-testing of exposures at the level of the individual hedge fund counterparty is becoming more common, still-wider application of this technique would be useful. Similarly, aggregate stress tests–by which a dealer evaluates its exposure to the hedge-fund sector in the event of a large market move–merit wider use. Aggregate stress tests are a desirable complement to stress tests of individual hedge fund counterparties because funds sometimes imitate each others’ strategies or choose strategies that are affected by common market factors. Supervisors are encouraging the expanded use of stress-testing when it is appropriate. Fourth, supervisors are concerned that the assessment of counterparty risks should be better tied to the amount of transparency offered by hedge funds. In particular, good risk management should link the availability and the terms of credit granted to a hedge fund to the fund’s willingness to provide information on its strategies and risk profile. Our supervisors are pushing banks to clearly link transparency with credit terms and conditions.

Since the Working Group report was issued, hedge funds have greatly expanded their activities and strategies, and their interactions with counterparties and creditors have accordingly become more complex. The continuing challenge for supervisors, counterparties, and hedge funds is to ensure that rigorous and appropriate methods of risk management are brought to bear even as institutions, instruments, and markets change. Two recent challenges of note are the spread of prime brokerage services and the emergence of operational issues in the settling of trades in newer types of over-the-counter (OTC) derivatives, particularly credit derivatives.

Hedge funds have long used arrangements that allow them to execute trades with several dealers but then to consolidate the clearing and settlement of their trades at a single firm, the “prime broker.” The prime broker typically provides financing and back-office accounting services to the hedge fund as well as settlement services. In the past couple of years, prime brokerage has expanded beyond cash trades for securities to include foreign exchange and OTC derivative trades, and more firms are offering prime brokerage services.

Prime brokerage poses some unique challenges for the management of counterparty credit and operational risk. Prime brokers must ensure that they have adequate information and controls to protect against counterparty credit risk arising both from the client and from the executing dealer. They also must implement internal controls to monitor and track transactions executed as part of the prime brokerage agreement and to ensure that the transactions meet the terms of the agreement. Supervisors of firms that offer prime brokerage services, particularly supervisors of new entrants, must ensure that the firms are fully aware of the risks involved and effectively manage them.

The proliferation of new financial products also poses risk-management challenges, including challenges on the operational side. For example, trading in credit derivatives has grown dramatically in recent years, and firms have had difficulties in processing and settling these and other OTC derivative trades in a timely way. These problems are not limited to hedge funds but affect all participants in the OTC derivatives market and all dealers in credit derivatives. Recently, supervisors in several jurisdictions, working with the Federal Reserve Bank of New York, have pushed firms to improve their processes for confirming and assigning trades. So far, good progress has been made, with private-sector participants meeting most of their objectives for reducing backlogs. Commitments are in place to effect still further improvement.

A noteworthy feature of these efforts is the cooperation among authorities. The Federal Reserve has devoted more effort in recent years to maintaining a dialogue with international supervisors, such as the U.K. Financial Services Authority, and we will continue to do so. Domestically, the Federal Reserve is coordinating with the SEC, which is the primary regulator of several large firms that deal in OTC derivatives or engage in prime brokerage activities.

Proposals for Creating a Database of Hedge Fund Positions
Following the LTCM crisis and the publication of the Working Group’s recommendations, the debate about hedge funds and the broader effects of their activities on financial markets abated for a time. That debate, however, has now resumed with vigor–spurred, no doubt, by the creation of many new funds, large reported inflows to funds, and a broadening investor base. Renewed discussion of hedge funds and of their benefits and risks has in turn led to calls for authorities to implement new policies, many of which will be topics of this conference. I will briefly discuss one of these proposals: the development of a database that would contain information on hedge-fund positions and portfolios.

It is commonly observed that hedge funds are “opaque”–that is, information about their portfolios is typically limited and infrequently provided. It would be more accurate to say that the opacity of hedge funds is in the eye of the beholder; the information a fund provides may vary considerably depending on whether the recipient of the information is an investor, a counterparty, a regulatory authority, or a general market participant. From a policy perspective, transparency to investors is largely an issue of investor protection. The need for counterparties to have adequate information is a risk-management issue, as I have already discussed. Much of the recent debate, however, has focused on the opacity of hedge funds to regulatory authorities and to the markets generally, which is viewed by some as an important source of liquidity risk. Liquidity in a particular market segment might well decline sharply and unexpectedly if hedge funds chose or were forced to reduce a large exposure in that segment.

Concerns about hedge fund opacity and possible liquidity risk have motivated a range of proposals for regulatory authorities to create and maintain a database of hedge fund positions. Such a database, it is argued, would allow authorities to monitor this possible source of systemic risk and to address the buildup of risk as it occurs. Various alternatives that have been discussed include a database maintained by regulators on a confidential basis, a system in which hedge funds submit position information to an authority that aggregates that information and reveals it to the market, and a public database with nonconfidential information on hedge funds.

I understand the concerns that motivate these proposals but, at this point, remain skeptical about their utility in practice. To measure liquidity risks accurately, the authorities would need data from all major financial market participants, not just hedge funds. As a practical matter, could the authorities collect such an enormous quantity of highly sensitive information in sufficient detail and with sufficient frequency (daily, at least) to be effectively informed about liquidity risk in particular market segments? How would the authorities use the information? Would they have the authority to direct hedge funds or other large financial institutions to reduce positions? If several funds had similar positions, how would authorities avoid giving a competitive advantage to one fund over another in using the information from the database? Perhaps most important, would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds’ risk-taking? A risk of any prescriptive regulatory regime is that, by creating moral hazard in the marketplace, it leaves the system less rather than more stable.

A system in which hedge funds and other highly leveraged market participants submit position information to an authority that aggregates that information and reveals it to the market would probably not be able to address the concern about liquidity risk. Protection of proprietary information would require so much aggregation that the value of the information to market participants would be substantially reduced. Timeliness of the data would also be an issue.

A public database of nonproprietary information could provide the public with a general picture of hedge-fund activity without creating the false impression that the authorities were engaged in prudential oversight of hedge funds. Such a public database might demystify hedge funds, but it would not address the central policy concern that opacity creates liquidity risk.

I expect discussion and analysis of the potential costs and benefits of increased disclosures will continue, as well as suggestions about how such disclosures might be structured and disseminated. The important challenge is to structure any disclosures in a way that does not generate moral hazard or weaken market discipline.

Conclusion
In the final analysis, authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again. Private market participants, too, have their role to play in ensuring that such lapses do not recur. The principles articulated in the CRMPG’s reports are a good starting place for firms, and senior management should rigorously assess their operations against those principles and commit the resources to address deficiencies. Authorities’ primary task is to guard against a return of the weak market discipline that left major market participants overly vulnerable to market shocks. Continued focus on counterparty risk management is likely the best course for addressing systemic concerns related to hedge funds. This public policy approach does not entail the moral hazard concerns created by authorities’ monitoring of positions using a private database. Rather, a focus on counterparty risk management places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so.
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2006 Speeches

 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.

 http://www.watsonwyatt.com/us/topics/htrender.asp?ID=14948

The Pension Protection Act of 2006 is the most significant overhaul of U.S. pension laws since the Employee Retirement Income Security Act (ERISA) was enacted in 1974.

Passed by Congress and signed by President Bush in August 2006, the Pension Protection Act (PPA) rewrites almost all major aspects of pension law, requiring defined benefit and defined contribution plan sponsors to make a number of changes. The bill’s most significant changes include:

• Establishing new funding targets for single-employer pension plans
• Imposing higher funding targets on at-risk plans
• Replacing the old discount rate with a modified yield curve of corporate bond rates
• Eliminating the full-funding limit for variable rate premiums
• Adding new requirements for multiemployer plans
• Clarifying hybrid pension plan rules
• Establishing new rules for 401(k)s and other defined contribution plans

Federal agencies are expected to issue regulations through 2008 that detail how employers must implement the act.

More

Related News

• Supreme Court Declines to Review Cooper v. IBM and Appellate Court Rules That Cash Balance Plans Are Not Age-Discriminatory  
• DOL Releases Guidance on Pension Benefit Statement Requirements Under the PPA 
• IRS Releases Grab Bag of Guidance on Pension Distributions 
• IRS Releases Transitional Guidance for Hybrid Plans 
• Phased Retirement: A Conflict in the Works? 
• Pension Plan Sponsors Changing Investment Focus, Watson Wyatt Finds 
• Congress Passes Landmark Pension Reform Bill 
• Five Aspects to Consider Before Changing Pension Plans 
• Watson Wyatt Urges Congress to Seize Opportunity to Shore Up Nation’s Pension System 

 http://www.watsonwyatt.com/topics/htrender.asp?ID=16307

With many countries rewriting their pension laws and accounting rules, employers are considering how to best structure their retirement plans. This is true in the United States, where sweeping new pension funding and plan design rules have just been signed into law; in Canada, where legal decisions and legislative changes are having a big impact; and in the United Kingdom, where companies continue to adjust to the legislative changes of recent years. Across the globe, pension plan sponsors face a host of complex financial, risk and demographic issues.

Regional Issues

• Pension Reform in U.S. 
• The New Pensions Framework (U.K.)  

More

Viewpoint
“Each company must assess its own needs as it weighs plan changes, and must make sure it takes into account its long-term business goals.”
Alan Glickstein, National retirement practice leader for policies and processes Five Aspects to Consider Before Changing Pension Plans  May 2006

Related News

• Pension Act Regulations Could Mean Significant Changes for 401(k) Sponsors, Watson Wyatt Says 
• Global pension fund assets double in ten years 
• Financial Health of Pension Plans Improving, Watson Wyatt Analysis Finds 
• Unbundling of DC expected to grow 

 http://www.watsonwyatt.com/us/pubs/insider/defined.asp

Default Investment Options in Defined Contribution Plans: A Simple Comparison
Employers increasingly provide retirement benefits to their employees through defined contribution (DC) plans. To build up enough wealth for a secure retirement, workers must save regularly and invest wisely. Automatic enrollment and effective default investments can help with both.  [March 2007]

DOL Releases Guidance on Pension Benefit Statement Requirements Under the PPA
In Field Assistance Bulletin (FAB) 2006-3, the U.S. Department of Labor provides guidance on the new requirements for benefit statements for both defined benefit and defined contribution plans, which were enacted by the Pension Protection Act of 2006 (PPA).  [February 2007]

How Will FASB’s Accounting Changes Affect Shareholders’ Equity and Credit Ratings?
On September 29, 2006, the Financial Accounting Standards Board (FASB) released its Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS 158). [December 2006]

DOL Proposes Default Investment Guidance
The U.S. Department of Labor (DOL) has proposed guidance concerning default investments in participant-directed defined contribution plans under ERISA section 404(c), as required by the Pension Protection Act of 2006. The guidance would protect plan fiduciaries if, in the absence of investment direction from the participant, the fiduciary invests the participant’s assets in a qualified default investment alternative (QDIA) and certain notice and other conditions are met. Plan fiduciaries would still have to prudently select and monitor any QDIAs under their plans. [November 2006]

Pension Fund Risk -

APT Risk Model

& Portfolio Analytics Solutions

APT’s system is used by national, state and corporate pension funds, both for oversight/monitoring and directly for asset management - for every asset class and across all geographical regions.

APT’s portfolio analysis system and risk models offer the pension fund comprehensive risk estimation & decomposition, portfolio construction tools, scenario and stress testing, and performance measurement.

Risk estimates are available based on robust, theory-driven foundations integrating:

• Statistical factors - for reliability
• Named factors - for intuitiveness, and
• Monte Carlo simulation - for handling extreme events

Profiles are estimated for all asset classes including:

• Equities
• Government bonds
• Corporate bonds
• Currencies
• Funds
• Hedge funds
• Futures options
• Real estate
• Commodities

Portfolios can be built or analyzed using any combination of these instruments, in any pools, packages or sub-funds, across single or multiple benchmarks. Profiles exist for almost every security in every major index - over 300,000 as of q2 2005 - which means the task of sourcing and cleaning data remains with APT.

Forecast models of market structure are available for:

• Short term (weeks) - for alternative investments or high risk satellite funds
• Medium term (months) - for standard equity and bond investments, or
• Long term (years) - for long term liability matches.

Risk can be decomposed by factors commonly used by institutional managers such as:

• Sectors, Countries and Styles - for equity managers
• Term structure factors and yield curve factors - for fixed income managers
• Macro factors used by economists or non-professional investors
• Any arbitrary factor selected or designed by the user, or requested by plan sponsors or trustees
• VAR breakdowns used by traders and some regulators

The software tools are designed to suit all types of users:

• With little quantitative experience but require comprehensive and reliable batch reports for all sub-funds, generated in-house for confidentiality reasons
• Who want technology outsourced, and require very large volumes of reports and analysis
• Who want to add analytics to their existing MS Excel® reports
• Who want to perform interactive portfolio analysis, and
• Who need to embed or integrate portfolio analysis software libraries with existing in-house software, 3rd party systems, or commonly-used data feeds

For those who want a ‘one-stop’ solution, APT can offer software integration services, as well as the technology itself, and can also arrange for the risk monitoring function to be carried out independently by expert consultants.

Pricing is modular & scaled, so you only need pay for what you use.

Take a look at what other software, risk models and portfolio analytics are available, or contact APT for a presentation, demonstration and example risk report for your fund or book

http://www.apt.com/en/solutions/pensionfunds.html

APT Company News

April 2007

John Blin, chairman of APT, will present “Optimal portfolio construction using asset allocation” to the World Funds Taiwan Conference on the July 9-11 at the Sheraton in Taipei. He will also be running a masterclass at this event titled “”Asset Allocation - All season strategy to outperform your peers”.

John Blin, chairman of APT, will lead a panel discussing “Identifying and managing the risks inherent to Indian hedge funds” at the HedgeFund World India Conference on the 14th September at the Hong Kong Conference and Exhibition Centre, Hong Kong.

March 2007

APT representative will be speaking on the topic of “Independent Component Analysis of Hedge Fund Returns” at the forthcoming CARISMA “Program Trading Techniques and Financial Models for Hedge Funds” seminar on 26-27th June in London.

[Advanced Portfolio Technologies (APT)
Advanced Portfolio Technologies (APT) was started nearly 15 years ago, when John Blin and Steven Bender began to develop the APT System. APT opened its New York office in 1985 and launched its first U.S. hedge fund in 1987. Currency and Japanese stock funds followed, and the company began to expand its business in Europe and Asia. Today, APT offers market participants around the world a precise, modern tool to manage portfolios effectively and flexibly. With the APT System, portfolio managers can monitor their true risk and control it to meet specific requirements - all within a suite of interlocking applications and programmable tools for multiple computer platforms.]