by Sam Won
(Excerpted from comments Sam Won made speaking at HedgeWorld’s 2011 Fall Fund Services Conference on Oct. 26.)
Too often there is a significant gap between what some hedge fund managers believe to be risk
management and what sophisticated, risk management-focused institutional investors know to be
so. A hedge fund can quickly move from an investor’s inbox to the trash when the fund exposes
its misunderstanding of some principles of risk management. Here are three examples of
mistakes to avoid.
Knowing what your market exposure is (e.g., long, short, gross and net) does not mean that
you know what your risk exposure is.
Just because you track the market value of your portfolio (e.g., price times quantity), does not
mean that you know what the market risks are in that portfolio. For example, suppose there are
two positions that you are long in your portfolio: $1mm of exposure to Alcoa and the same
exposure to Pfizer. Although from a market value perspective both positions are identical, they
do not have the same market risk. For one thing, Alcoa’s recent volatility was almost twice that
of Pfizer’s. So, the Alcoa position would be significantly more “risky” just on a volatility basis.
Most portfolio managers would probably agree that the risk profiles of these two positions are
not the same yet when they manage their overall portfolios they assume that it is sufficient to
know their long, short, gross and/or net exposure (e.g., market value) to understand and manage
the market risk of their portfolios.
Here’s another example. Some fund managers claim they manage their risks by increasing or
decreasing the gross and/or net exposure levels of their portfolio. What’s wrong with this picture?
First, they mistakenly assume their long and short exposures naturally offset each other and that
market risk can be managed simply by modulating gross or net exposure. Second, this approach
doesn’t address what is driving the market risks of the portfolio (e.g., volatility, momentum, etc.);
it’s only a belated, reactive response to the portfolio’s current market price level. Third, in times
of high volatility we have seen many managers give up upwards of 5% in friction costs trying to
cut risk after the markets already moved against them. You cannot predict or control the market
price movements of a portfolio. So, it is a futile exercise for a fund manager to try to manage
market risk by merely tracking and trying to adjust the exposure level of a portfolio.
Market risks are not linear.
Many risks in a portfolio can have either explicit or imbedded optionality. In times of crisis or in
stressed markets most investment portfolios’ performance and risks do not behave in a linear
fashion. This is why the losses and/or gains in many fund managers’ portfolios have recently
moved in non-linear ways and have been far greater than expected or estimated. This year we
have all read about a number of marquee name managers who racked up considerable losses
because the non-linear risks in their portfolios when combined with leverage created a deadly
combination that put them in positions where they are now down in many cases over 40% on a
year to date basis.
Correlations are not either “0” or “1”.
How often have we heard many knowledgeable market analysts and fund managers make
pronouncements that correlations are moving to “1”? This flawed notion assumes that markets
behave in almost a binary fashion. It also incorrectly assumes that the correlation values that lie
between “0” and “1” are somehow less important or not important. In reality, correlations values
can be between -1 and +1 and, especially in volatile markets, there are many values between
these two numbers that can adversely affect a portfolio.
It is crucial for fund managers to understand what the current correlations are in the portfolio as
well as what happens to risk and performance when the correlations in that portfolio are stressed.
For example, we encountered a fund manager who did not realize how closely correlated his
fund was to the Russell 2000 Index. We wanted to say to him “Dude, your investors are not
going to pay you two and twenty for glorified beta.” In addition, our analysis revealed that he
had put much of the portfolio on a one-way bet on economic recovery and so he did not realize
the extent to which the performance of his portfolio was so closely correlated to cyclical sector
stocks.
We have had a number of institutional investors tell us that one of their chief concerns is whether
their managers are delivering true beta. For that reason, nearly all of the institutional investors
we are aware of evaluate their managers’ performance on a regular basis to check whether they
correlate to any of the major benchmark market indices. In addition, we are finding that more
investors are also looking to determine whether their fund managers are able to fully evaluate
and track the correlations within their portfolios they manage.
After 2008, investors are keenly aware that an integral part of whether a fund manager
understands his risks can be determined by whether he knows what his correlations are in his
portfolio.
# # #
Samuel K. Won is the Founder and Managing Director of Global Risk Management Advisors, Inc.
(www.grmainc.com), a leading independent risk management advisory firm that provides advisory services to asset managers and institutional investors. He has over 25 years of risk management, capital markets, trading and portfolio management experience at major financial institutions, and has advised regulatory agencies, such as the SEC, the Federal Reserve Bank, the Office of the Comptroller, FHLBB and the FSA, on major risk management, trading and capital markets issues and policies. He can be reached at 212-230-1610 or info@grmainc.com.
To view the full PDF of the article, please click here.