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Reproduced from Hedge Funds Review
May 2001, Issue 8, Cover Story
Walking a fine line
By Sophie Radnor
Investors and fund managers are looking for effective and affordable risk management services, learning their lesson from the near collapse of LTCM. Most problems encountered with risk profiling can be met by using the right software packages, but how affordable are these to small hedge fund managers?
“The institutionalisation of hedge fund investing is encouraging a greater degree of transparency from hedge fund managers. Risk management is being considered by more managers, especially if they are in the mode of raising money,” says Peter Bernard, executive director of Riskmetrics. Smaller hedge fund managers are caught in a vicious circle, Bernard believes, as risk management software is expensive. So, how can they convince investors that their risk management is effective?
Bob Boettcher of Algorithmics, a risk management software provider, believes that the fallout from the near collapse of Long Term Capital Management (LTCM) has been a catalyst in improving risk management in hedge funds. He cites the recent report Sound practices for hedge fund managers, which was a response to the President’s Working Group on Financial Markets report, concerning the lessons of LTCM calling for greater transparency and more effective risk management practices.
Niall McIntyre of Xenomorph, a risk management software company based in London, agrees: “The report presents many challenges to risk managers in hedge funds. Market risk, credit risk, funding liquidity and leverage are identified as a distinct, and potentially toxic, cocktail of challenges for risk managers in hedge funds. These risk managers are often not afforded the budget or IT resources available to their investment bank counterparts. This can also be compounded by the fund’s ability to trade a diverse range of asset classes. However, even for funds with complex and diverse portfolios, the risk management challenges set out in the report can be met by using software solutions.”
McIntyre believes that investors are driving the demand for better risk management: “Investors want to see risk numbers in order to produce analysis on their returns. Funds of funds want specific risk profiles to fit with the other investments they are making”.
Stephen Ashworth is senior managing director of the consulting division of Reech Capital which provides a risk management service. Their software evaluates Value at Risk (VaR) and enables stress testing on any derivative or structured product. He says: “Hedge funds have diversified, sophisticated portfolios. They can have complex risk management requirements. Different trading strategies can mean exposure to different levels and types of risk - compare convertible bond arbitrage with long/short equity trading for instance”.
As indicated in the Sound practices... report, hedge funds have special requirements of risk management. Algorithmics explains the differences between the risk management needs of hedge funds, in comparison with traditional investment managers and sell-side departments of banks and financial institutions. Boettcher says: “Hedge funds have characteristics in between that of traditional investment managers and that of the sell side. With a hedge fund, often their portfolios contain derivatives and also more complex emerging market positions. They normally want to look at risk over a longer horizon, often three months, maybe even longer.
Bernard agrees and explains: “Hedge funds are more similar to sell side in their trading strategies. They tend to separate their portfolio into a number of discrete strategies under an overall strategy umbrella. The hedge fund manager wants, hypothetically, to see the risks of each trade as well as the whole portfolio.”
Boettcher adds: “Since they have highly leveraged strategies, but not, in many cases, a very strong capital base, they have to look at risk from an absolute perspective to make sure they don’t execute a strategy that puts them out of business”.
Boettcher also points out: “Hedge funds have smaller budgets. That ties into the different delivery models for risk management to the hedge fund industry”
There are two generic approaches to risk management which Boettcher outlines. “The mean/variance framework is the classical approach to risk management. In this approach, you make a lot of assumptions about the characteristics in the portfolio, how markets evolve and positions that don’t change. By making those assumptions, the advantage is that you can come up with closed-form solutions that can be calculated very quickly. It is an approach that has been in use by the investment industry for decades, but there are disadvantages that come with it”.
The alternative is a scenario-based approach which Algorithmics refer to as Mark-to-Future. Boettcher says: “We assess risk by looking at the effect of different scenarios on the values of your holdings. These scenarios can come from many sources, the portfolio managers’ or the risk manager’s experience, or from historical experience. So, what if the Asian crisis were to repeat itself? Or be more severe? Less severe? What if the Russian crisis were to repeat itself, but maybe not in Russia, but some other jurisdiction? Or, it can also come from statistical techniques. The key thing with Mark-to-Future’s scenario-based framework is that you don’t need to make any heroic assumptions. People come up with scenarios and then look at the risk under each one.
McIntyre outlines the risk management options available to hedge fund managers. “Firstly, you could build yourself something on Excel. You might do this because you think you are knowledgeable about how risk works and you believe you are making a cost saving”. However, he warns: “A hedge fund cannot build a credible trading and risk management system using Excel alone. Flexibility makes Excel the tool of choice for many hedge fund managers, quantitative analysts and risk managers.
However, as regulatory and investor pressure demand that ever more stringent systems are put in place, it is questionable if an Excel-only solution can realistically meet these demands”. Boettcher agrees: “The problem is that as soon as you want to do something new or different, you have to extend the spreadsheet. This means that you have a lot of development and operational risk because the models that are built into the spreadsheet, in many cases, are not vetted by anyone else. In the case of our software, it is used by about 120 financial institutions around the world, so we are confident our models are good”. Bernard agrees: “We always say our two biggest competitors are ‘do nothing’ and ‘build it in-house’. Some of the more exotic hedge fund strategies have been tough for external software suppliers, but that gap is narrowing. Many hedge fund managers are just hiding behind a cloak of secrecy”.
Ashworth says: “Traditionally, risk management was handled internally. As the hedge fund world opens up in terms of transparency, managers look more credible if they use dedicated risk management products”. These software systems come in two different forms, as an off-the-shelf system where the vendor sells the software and it is integrated into the buyer’s system or as an ASP, (Application Service Provider) where web access is provided to the software, which is rented. ASPs are less expensive than off-the-shelf products. Reech Capitals software is only available as an ASP This enables managers to pay on a usage basis with no upfront fees. “This makes it affordable for smaller players and gives them access to highly technical risk software”. Boettcher says: “It is a lower cost alternative, but with a lower cost, you usually lose a bit of flexibility.”
Riskmetrics have a flagship product called RiskManager. Bernard says: “It is suitable for anyone with a financial portfolio who needs to assess their exposure to risk”. The product is also suitable for investors through a functionality called TAGS, which says Bernard, “can group things together such as securities but also portfolios. This turns the product into a giant data viewer”. RiskManager is available in a variety of packages and the basic model costs $50,000, although Bernard says, “in order to pull smaller funds in we have set up a price system on a long-term contract as a percentage of NAV, essentially a charge on total assets”.
PerfectVine is the new product from Xenomorph that is designed exclusively for hedge funds. It manages market risk, credit risk, interest rate risk, derivatives risk, scenario analysis and yield curve analysis as well as being a trading tool. “The system is scalable and more affordable for a smaller hedge fund”, says McIntyre.
Prime brokers offer access to risk analysis for their hedge fund clients. McIntyre says: “Prime brokers have much of the information needed to produce risk management reporting. But, the move towards multiple prime broking means that one alone does not have all the information. The attempt to consolidate can lead to hearsay reporting”. This means that one prime broker compiles the trade history of the fund, depending on what the hedge fund manager reports as the trades he has done with other prime brokers. As part of the growing trend of prime brokers expanding the range of services they offer to hedge fund clients, they are starting to provide access to software, through shared initiatives with software providers.
Nick Roe is managing director of global equity finance sales at Deutsche. He has overseen the recent buyout of RAROC by Deutsche and its rebranding as the DB Risk Office product. This was originally aimed at the institutional market and has been developed into a more “hedge fund friendly product”. DB Risk Office will continue to be commercially sold but is available to hedge fund clients of Deutsche, as Roe says: “It is part and parcel of our prime broking offering”. The software is web enabled and provides risk analysis as well as ‘what if’ scenarios, and with the use of hedge fund index data can benchmark any of the risk/performance of the fund. Deutsche is aiming at responding to the needs of investors, as well as fund managers, by allowing hedge fund clients’ investors access on the fund manager’s request. Roe says: “Our perspective is that this is not just about prime broking but is part of equity finance. If we have this detailed risk information about our hedge fund clients we should make it available to the fund manager. We set targets although we have a conservative margin policy, and won’t allow hedge fund clients to be that highly leveraged.” Roe agrees it is difficult for small hedge funds to get access to good software: “Our client base has typically been larger hedge funds. We have a high barrier to entry and have made a big investment in this software. It is becoming more and more difficult for a smaller hedge fund to find a provider in the prime broking market. A risk management software house offering a keenly priced product for hedge fund managers would do very well”.
Algorithmics have agreements with two prime brokers to use the Algorithmics Risk Engine inside their prime brokerage service. Boettcher says: “Our strategy for the smaller and medium-sized hedge funds who don’t have the sophistication or budgets to deploy our software on site, can get service through the prime brokers with Algo Engine inside. For the larger hedge funds that do have the budgets, they can buy our software directly”.
Boettcher adds: “One of the motivations for the prime brokers to add risk management to their offering is to encourage the hedge fund to do more business with them.
Ashworth says: “We have had a lot of interest from prime brokers in our system. This is because we are independent which adds a degree of credibility”.
Bernard believes that fund administrators could also be a provider of risk management information to hedge fund managers. He says: “Offshore administrators produce the NAV for the fund. They reconcile the funds’ positions with the prime broker each month. There aren’t so many administrators out there that we, or others, could not do some link-up with them. It would be an easy add on service for them”.
Ashworth agrees: “In theory, the fund administrators are the ideal people to provide risk analysis - it is a logical extension of their service. However, their level of understanding and quantifying risk is not very sophisticated.”
Bernard believes that another source of risk analysis will be investors. “We will see some projects sponsored by fund of fund investors which hedge funds can subscribe to. They will not be provided with an interactive model but can get monthly static reports”. Ashworth adds: “Investors do not have the underlying position information about the fund that prime brokers or administrators have. But from an investor point of view, in order for hedge funds to go to the next level in terms of acceptability, there has to be more transparency and a benchmarking standard of risk.”
Hedge Funds Review, May 2001, Issue 8, Cover story
By Sophie Radnor