When trying to maximize absolute returns, the importance of assessing and mitigating risk shouldn’t be underestimated. Some memorable examples like LTCM and Tiger Fund not only show how heavy losses can be for some participants of the hedge fund industry, but also reinforce the perception that a good record of high absolute returns can mean absolutely nothing in an environment of improperly managed risk.
The most important lesson in terms of Hedge Fund Risk Management comes from the improper name of this kind of alternative investment: The idea that all systematic risks are diversified away is not applicable here, with the Hedge Fund returns, in reality, representing a combination of superior management of market inefficiencies and conscious exposure to some specific systematic risks. Only the systematic risks that are “undesirable” from a strategic point of view are diversified away. So, hedge funds, in reality, are not fully hedged.
Moreover, the adequate measure in terms of risk management exposure moves from the realm of excess risk in comparison to a benchmark to a total risk approach. Total return here is what matters for managers and investors and not a comparison of the hedge fund performance to some benchmark, like in other types of funds.
Also, the leptokurtosis (“fat tails”) and negative skewness associated to most class of hedge funds present a significant challenge to quantitative methodologies based on the assumption of returns normality (e.g. Riskmetrics classic approach), with the area becoming a very good study case for new approaches, like Extreme Value Theory (EVT).
Finally, with this complex framework in mind, the need for an initial and constant due diligence and managerial tracking surges as the most important issue from an investor’s or fund of funds’ perspective. Here, the obligation of full portfolio transparency (for legitimate investors, but not for the whole market) becomes mandatory for the successful risk manager, while, of course. other types of risk commonly not addressed through quantitative methodologies, (e.g. the liquidity barriers established through long “lock-up” periods) can’t also be underestimated.
Once aware of the formal conditions offered by a hedge fund manager, knowing your manager’s style in-depth and keeping frequent meetings and discussions based on updated full portfolio/single positions disclosures is the key to avoiding pitfalls as an investor.