Measuring the Risk of Hedge Funds

Measuring and reporting the risk of hedge funds requires a customized approach. While hedge funds may invest in the same instruments as other investors, and the analytical models to evaluate the holdings of hedge funds are the same as for other investors, the reporting of hedge fund risk is very different from risk reporting for other investment vehicles.

The essence of a good hedge fund strategy is that the manager has identified a market segment or trading strategy that produces excess return (alpha). The source of value could be that other market participants are restricted from using the instruments or strategies employed by the hedge fund manager. Therefore, tools that are appropriate for other instruments may not be appropriate for hedge fund strategies.

Much hedge fund risk analysis looks at the past performance of the fund to determine if the risks are in line with the investors' expectations about the degree of risk and the correlation of the risks with other market indices. Historical return-based measures, such as Sharpe ratios and other variants, may be useful tools for screening managers, but they may not provide a complete picture of prospective risk characteristics.

Generally, hedge funds may differ from other pooled investments in three ways:

    1. The fund may employ a higher degree of leverage than other investments
    2. The primary risk is not the sector risk, so the fund should have a low correlation with market         indices.
    3. The fund may invest in instruments that are not commonly used.

It is necessary to take these differences into account when evaluating hedge fund risk. Since a hedge fund can be very leveraged, it can be exposed to very large risks. The first step in evaluating hedge fund risk is to determine the amount of leverage in the strategy. Leverage takes two forms, explicit and implicit. Explicit leverage results from borrowing, either term or repo. Implicit leverage reflects the leverage built into the instruments used in the strategy. Futures, options and swaps all represent leveraged investments. Inverse floaters and IOs are also leveraged in that they bear more risk than the typical instrument in the sector. The degree of implicit leverage can be determined either analytically >>>