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User:Bryant Park Fifth/Hedge fund

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Hedge fund risk

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Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures.[1] Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk.[2] Hedge funds ideally produce returns relatively uncorrelated with market indices.[3] While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.[4]

Risk management

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Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."[2] Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models.[5] A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy.[6][3] Some factors ,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk as a measurement of risk may compensate for this by employing additional models such as drawdown and “time under water” to ensure all risks are captured.[7] In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence, a technique used by hedge funds to assess the risks of an investment paired with financial risks. Operational due diligence is also used by investors in hedge funds to assess the operational risk of investing in a particular fund. This technique involves examining the operations of the fund or investment to identify any risks, in particular identifying whether the investment strategy is likely to produce a risk-adjusted return that is consistent with the investor's objectives, how sustainable the fund's operations are, and the fund's ability to develop as a company.[8]

Transparency and regulatory considerations

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Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.[9] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.[6] New regulations introduced in the U.S. and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency.[10] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.[2] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.[11]

Risks shared with other investment types

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Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.[6] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money.[12][13] Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk and leverage risk.[9] Valuation risk refers to the concern that the net asset value of investments may be inaccurate;[14] capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration;[15] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.[16] These risks may be managed through defined controls over conflict of interest,[14] restrictions on allocation of funds,[15] and set exposure limits for strategies.[16]

Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns,[12] subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.[5]

Many investment funds use leverage, the practice of borrowing money or trading on margin in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.[12] Hedge funds employing leverage are likely to engage in extensive risk management practices.[9][5] In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.[17]

Debates and controversies

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Systemic risk

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Systemic risk refers to the risk of instability across the finance industry, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity.[18] Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby has described hedge funds as "small enough to fail".[19][20] Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis.[21] In testimony to the House Financial Services Committee in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he “would not think that any hedge fund or private equity fund would become a systemically-critical firm individually”.[22]

Organizations such as the National Bureau of Economic Research[18] and the European Central Bank have charged that hedge funds pose systemic risks to the financial sector,[23][24] a claim disputed by parts of the financial industry, including the Risk and Asset Management Research Centre at EDHEC.[25] The failure or near failure of large hedge funds has been cited by media commentators as an example of the potential for systemic risk, in particular the failure of Long-Term Capital Management (LTCM) in 1998. However, no financial assistance was provided to LTCM by the U.S. Federal Reserve, incurring no cost for U.S. taxpayers.[26]

In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system."[27] In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.[28][29]

References

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  1. ^ Davidoff, Steven M. (17 September 2009). "To Reduce Hedge Fund Risk, Let Everyone In". The New York Times. Retrieved 27 March 2011.
  2. ^ a b c Jones, Sam (21 March 2011). "Hedge funds: Stringent controls on losses and investment". Financial Times. Retrieved 30 March 2011.
  3. ^ a b Lo, Andrew (2001). "Risk Management for Hedge Funds: Introduction and Overview" (PDF). Financial Analysts Journal. 57 (6). CFA Institute: 16–33. Retrieved 29 March 2011.
  4. ^ "Hennessee: Protecting capital during market downturns". Hedge Fund Journal. 22 July 2010. Retrieved 30 March 2011. {{cite web}}: Check |url= value (help)
  5. ^ a b c Cassar, Gavin; Gerakos, Joseph. "How Do Hedge Funds Manage Portfolio Risk?" (PDF). EFM Symposium. European Financial Management Association. Retrieved 17 March 2011.
  6. ^ a b c Jaeger, Lars (28 April 2005). "Risk Management for Hedge Fund Portfolios" (PDF). Presentation at ETHZ [Eidgenössische Technische Hochschule Zürich]. Partners Group. Retrieved 17 March 2011.
  7. ^ "López de Prado, M. and A. Peijan: Measuring Loss Potential of Hedge Fund Strategies", Journal of Alternative Investments, Vol. 7, No. 1, pp. 7-31, Summer, 2004
  8. ^ Jaffer, Sohail (2006). Hedge funds: crossing the institutional frontier. Euromoney Books. pp. 113–4. ISBN 1843742683.
  9. ^ a b c Ineichen, Alexander (2002). Absolute Returns: the risks and opportunities of hedge fund investing. Wiley, John & Sons, Incorporated. pp. 441–4. ISBN 0471251208.
  10. ^ Chay, Felda (27 November 2010). "Call For Joint Effort to Protect Hedge Fund Business". The Business Times Singapore. Singapore Press Holdings. Retrieved 8 March 2011.
  11. ^ White, Jody (25 January 2010). "Institutional investors changing the rules of hedge fund investing". BenefitsCanada.com. Retrieved 30 March 2011.
  12. ^ a b c "What is a Hedge Fund". BarclayHedge LTD. Retrieved 28 March 2011.
  13. ^ Coggan, Philip (2011). Guide to Hedge Funds (2nd ed.). The Economist Newspaper Ltd.
  14. ^ a b Strachman, Daniel A.; Bookbinder, Richard S. (2009). Fund of Funds Investing: A Roadmap to Portfolio Diversification. Wiley, John & Sons, Incorporated. pp. 120–1. ISBN 0470258764.
  15. ^ a b Avellanda, Marco; Besson, Paul. "What is a Hedge Fund" (PDF). New York University. Retrieved 28 March 2011.
  16. ^ a b "Concentration Risk". Quant Risk Group. 2008. Retrieved 29 March 2011.
  17. ^ Ang, Andrew; Gorovyy, Sergiy; van Inwegen, Gregory (2011). "Hedge Fund Leverage: NBER Working Paper No. 16801" (PDF). NBER. Retrieved 4 April 2011. {{cite journal}}: Cite journal requires |journal= (help)
  18. ^ a b Chan, Nicholas; Getmansky, Mila; Haas, Shane M; Lo, Andrew W (March 2005). "Systemic Risk and Hedge Funds". National Bureau of Economic Research. Retrieved 27 March 2011.
  19. ^ Mallaby, Sebastian (2010). More Money Than God: Hedge Funds and the Making of a New Elite. Penguin Group. ISBN 1594202559.
  20. ^ Protess, Ben (19 November 2010). "No Threats Here, Firms Tell the U.S." The New York Times. Retrieved 28 March 2011.
  21. ^ Rooney, Ben (18 December 2008). "Hedge fund graveyard: 693 and counting". CNNMoney.com. Retrieved 5 April 2011.
  22. ^ "Testimony of Douglas Lowenstein President/CEO, Private Equity Council House Financial Services Committee" (PDF). House.gov. 6 October 2009. Retrieved 5 April 2011.
  23. ^ "Financial Stability Review June 2006" (PDF). June 2006. Retrieved 2010-08-14.
  24. ^ Gary Duncan (2006-06-02). "ECB warns on hedge fund risk". London: The Times. Retrieved 2007-05-01.
  25. ^ "A reply to the ECB's statement on hedge funds by the EDHEC Risk and Asset Management Research Centre" (PDF). edhec-risk.com. Retrieved 2010-08-14.
  26. ^ Bookstaber, Richard (2007-08-16). "Blowing up the Lab on Wall Street". Time.com. Retrieved 2010-08-14.
  27. ^ Armitstead, Louise (23 February 2010). "Hedge funds do not pose systemic risk, concludes FSA". The Telegraph. Retrieved 28 March 2011.
  28. ^ "Assessing possible sources of systemic risk from hedge funds" (PDF). FSA.gov. Financial Services Authority. February 2011. Retrieved 27 March 2011.
  29. ^ "Assessing possible sources of systemic risk from hedge funds" (PDF). FSA.gov. Financial Services Authority. February 2010. Retrieved 27 March 2011.
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