The credit crunch continues to make headlines both in terms of its impact on financial markets and on wider economic activity. In these challenging market conditions, risk management is more crucial than ever for hedge funds, as some recent well-publicised blowups have graphically highlighted.

There are many different types ofhedge funds. However, most of them have the following characteristics, potentially setting them apart from other types of asset managers:

• They are particularly focused on delivery of alpha
• They often respond particularly rapidly to market events
• They typically take sizeable positions, often employing leverage and shorting
• Their search for alpha may take them into relatively less well researched areas and may involve use of more sophisticated and potentially less liquid instrument types

Risk management is crucial in each of these areas:

Alpha delivery

Investors typically aren’t just interested in alpha in some abstract sense; they also want alpha delivery to make sense in the context of the investor’s overall risk budget (because an investor’s holding in any particular hedge fund doesn’t typically exist in splendid isolation, but actually forms part of a wider portfolio).

So, investors are very interested in the nature of the risks being expressed in a hedge fund, as well as the potential rewards that it might deliver. In turn, hedge fund managers need to have a keen appreciation of risk if they are to do a good job for their investors (and if they want to be able to explain what they are doing to those same investors).

Rapid response to market events

In some respects, hedge funds behave as if they are operating to an internal ‘clock’ that runs more rapidly than for more traditional portfolios. Investors typically accept a shorter track record before investing in a hedge fund, but are correspondingly less forgiving of a short-term performance downturn. Taking the analogy one stage further, high performance cars typically need high performance brakes etc. So it is not surprising that good hedge funds typically place a premium on good risk management.

Employment of leverage

Hedge funds also typically take larger (and more dynamic) positions than more traditional portfolios. This makes them potentially more exposed if things go wrong.

Use of more sophisticated instrument types and focus on less well researched market areas

Hedge fund managers constantly innovate in order to keep one step ahead of the competition in the search for alpha. But this, of course, also makes it particularly important for them to appreciate that the market areas and instruments they use might behave in unexpected ways.

A particular risk that seems to have come to the fore recently is that of so-called ‘crowded trades’. This applies not just to hedge funds focusing on less liquid strategies but also to ones employing more straightforward styles, eg. equity long/short. Hedge funds often (potentially unwittingly) seem to end up adopting similar positions to those of their close competitors. So they can be caught out even if there is just a change in risk appetite affecting their competitors, because the consequential position unwinds then affect their own positions. This risk has arguably been latent for quite some time, as the hedge fund industry has seen stellar growth rates, but has become more pronounced more recently because of the greater volatility in risk appetite we are seeing in the current market climate.

The more spectacular hedge fund disasters of recent times have typically been compounded by leverage. It was arguably excessive leverage that was the particular undoing of the great granddad of them all, LTCM. So, we will explore in more detail some particular issues relating to managing leveraged portfolios. In this context we take ‘leverage’ to mean any strategy in which there is some explicit ‘borrowing’ taking place by the portfolio in question. Otherwise almost any strategy might be deemed to involve leverage if only indirectly, eg. most equity investment is into companies that themselves have debt outstanding or have taken out loans from banks.

Such leverage can have the following impacts on portfolio behaviour:

(a) Leverage magnifies upside and downside. This is normally the main rationale for employing leverage, particularly by hedge funds. Return potentials in some areas may be inadequate to meet investor expectations without the use of leverage.

(b) Leverage introduces risks not previously present because of the need to fund the borrowing required to achieve the leverage, including:

• Liquidity risk: The entity lending to the portfolio may in the future become unable or unwilling to continue to support the leverage currently being employed by the portfolio, or may be willing to do so only at materially increased cost.
• Forced unwind risk: The funding arrangements may only be available alongside terms that require automatic unwinding of positions in certain adverse circumstances, potentially locking in (very) poor returns to investors. This type of risk is typically implicit in prime brokerage arrangements, the bedrock currently used by many hedge funds to implement their desired leverage levels. In effect, they contain catastrophe option elements. If they are ever triggered (eg. because market liquidity dries up at the same time as there is very substantial investor outflow) then there can be drastic consequences.
• Variable borrow cost risk: The market rates for the type of borrowing in question may rise unexpectedly.