Hedge Fund Managers Take Institutional Approach to Risk

Terry Flanagan

Hedge funds are increasingly incorporating sophisticated risk management techniques to satisfy institutional investors.

The employment of risk measures such as Value-at-Risk (VaR), a staple of bank capital adequacy reporting, is now being used to track the performance of actively managed portfolios.

“Retail and institutional investors demand to have more diversified portfolios,” said James Dilworth, CEO and founder of Simple Alternatives. “They are looking for solutions that can help enhance risk-adjusted returns and that have low correlation to traditional investments like stocks and bonds. Investors are concerned about seeing big draw downs and want solutions that can provide a degree of downside protection during market volatility. These have been some of the biggest drivers of alternative asset flows.”

James Dilworth, Simple Alternatives

James Dilworth, Simple Alternatives

According to Morningstar, alternative mutual funds saw inflows of $19.7 billion in 2012. Notably, this growth in alternative mutual fund use includes institutions – 45% of which said they access long-short strategies via mutual funds versus 38% in 2010.

“The advent of using the 40 Act mutual fund structure for accessing hedge fund managers raises investor access to a whole new level,” Dilworth said. “Our S1 Fund (SONEX), for example offers direct access to long/short equity managers to a wide range of investors, with the benefits of daily liquidity, high transparency and lower investment minimums.”
40 Act mutual funds are becoming the dominant structure used by both advisors and institutions to access the majority of alternative strategies.

“While the 40 Act mutual fund structure is not a fit for all hedge fund strategies, the majority of hedge fund strategies can be managed identically to their limited partnership flagship funds,” said Dilworth. “In fact, there are significant structural advantages for 40 Act Mutual Funds that include increased transparency, daily liquidity and lower fees.”

While other structures such as ETFs or separately managed accounts may be viable for hedge fund replication strategies, the short selling component of most hedge fund strategies is very difficult to implement in these structures.
“It is unlikely that you will see “true” hedge fund portfolios available to investors in an ETF or SMA,” Dilworth said. “The exception would be large institutional investors who have the infrastructure and can meet the high investment minimums to access hedge fund managers via a customized separately managed account.”

Active managers are increasingly being required by institutional investors to report VaR and other risk management statistics in order to obtain institutional funding.

“The cost to build out an internal risk management function or use an external risk management advisory can be a significant expenditure,” said Jerry Waldron, director of risk management and portfolio analytics at Woodbine Associates, in a report. “Active managers are well advised to not consider these expenditures as simply a cost of doing business, but are better served by integrating risk management into their investment process.”

Incorporating VaR can be valuable in analyzing alternative investments. On a tactical bias, the inclusion of VaR and other risk management measures enables asset managers to compare an active managers’s actual performance to a passive index, thereby insuring that the manager continues to deliver the performance for which it is being compensated, Waldron said.

VaR is a statistical measure of the amount of capital that could be lost with a given level of certainty over a given time period.

For example, an asset manager deciding between an investment in a passive index or an actively managed portfolio might observe that both portfolios have the same risk-return exposures at the tail ends of the portfolio (below the 5th percentile and above the 95th percentile) but show dramatically different returns at all points between the 5th and 95th percentiles.

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