Hedge Fund Risk Fundamentals is the first book to bringthese issues to the forefront. With clarity, concision, and minimalmath, Richard Horwitz lays out the key components and thecutting-edge processes in the field of hedge fund risk managementtoday. Against that backdrop, he presents a groundbreaking utilitydestined to set the standard for transparency and risk managementwithin the hedge fund universe.
You’ll learn why, when it comes to risk management, 1 + 1= 1.41. For all of those perplexed by the difficulties of assessingrisk in hedge fund investing, Horwitz’s concepts make for aninvaluable road map and a demystifying resource that hedge fundsand investors at all levels will find indispensable.
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Hedge Fund Risk Fundamentalssolving the risk management and transparency challenge
By Richard Horwitz
Bloomberg PressCopyright © 2004 Risk Fundamentals LLC
All right reserved.
Volatility is the primary component of risk. Volatility exists when outcomes are uncertain. For example, assume you repeatedly flip a coin and this is from each flip:
You earn $1 if the coin lands on heads (50 percent probability).
You earn $3 if the coin lands on tails (50 percent probability).
Your expected return for each flip will be $2, the average of $1 and $3. The average absolute deviation from the expected return-that is, the volatility-will be $1. That's because if the coin lands on heads you will earn $1 less than the expected return, and if it lands on tails you will earn $1 more than the expected return.
Now let's analyze a second payout scenario:
You do not earn anything if the coin lands on heads (50 percent probability).
You earn $4 if the coin lands on tails (50 percent probability).
Your expected return for each flip will still be $2, the average of zero and $4. The average absolute deviation will now be $2. (The absolute deviation from the mean of $2 of both outcomes will be $2, so the average absolute deviation will be $2.) The two scenarios have the same return and different volatilities.
In general,the greater the level of risk taken, the greater the level of return expected. If the above examples were restated as alternative investments, no investor would choose to take the second investment, which would have equivalent returns but greater volatility. However, there is a floor to returns called the "risk-free rate." That is, a risk-free investment (such as the 90-day Treasury bill) will earn a baseline return to reward the investor for committing capital. (In our simple example, there was no commitment of capital, just a payout.) Therefore, the typical relationship between return and volatility is as shown in Figure 1.1.
Investments that fall on this line are considered to be "efficient." The "efficient market theory" argues that markets are efficient over time and that returns are commensurate with the level of risk. This implies that over the long term returns should fall on the efficient line as shown in Figure 1.1.
Because investments with higher volatility should command higher returns, you cannot evaluate a return without simultaneously considering the risk associated with that return. For example, the two hypothetical funds in Figure 1.1 had the following payout:
Fund A had a volatility of 1 percent and a return of 6 percent (above the efficient line).
Fund B had a volatility of 12 percent and a return of 7 percent (below the efficient line).
From a perspective of risk efficiency, Fund A would be the preferred choice, despite the fact that it generated a lower absolute return. This demonstrates the need to measure performance on a "risk-adjusted" basis, not an "absolute" basis. More than forty years ago, William Sharpe, a Nobel laureate and pioneer in financial theory, developed the Sharpe ratio, which provides a measure that appropriately adjusts returns for the level of volatility. The Sharpe ratio is the mainstay of hedge fund risk statistics:
Sharpe Ratio = Return-Risk-Free Rate/ Volatility
Assuming a 4 percent risk-free rate, the Sharpe ratio of Fund A, therefore, is 2 (the difference of 6 percent and 4 percent, or 2 percent divided by 1 percent), and the Sharpe ratio for Fund B is 0.25 (the difference of 7 percent and 4 percent, or 3 percent divided by 12 percent). The higher the Sharpe ratio, the better the risk-adjusted returns.
Despite the fact that Sharpe has recently questioned the validity of his formula, given the practical problems with hedge fund return data (discussed in Chapter 5), this formula for comparing the risk-adjusted returns is widely applied throughout the hedge fund world.
The Capital Asset Pricing Model (CAPM) takes the efficient market theory one step further, concluding that the only risk that is compensated (or that produces return) is "market" risk. This is based on the assumption that the markets are 100 percent efficient and that risks other than market risks (such as exposures to styles or sectors) can be diversified away. If risks other than directional market risk can be shed through diversification, the theory concludes, there is no reason that investors should be compensated for taking these other risks.
However, the direct implication of this theory is that hedge funds cannot earn a positive return. Hedge funds, after all, explicitly target, rather than shed, risks other than directional market risk to generate "alpha"-that is, returns in excess of those generated by taking directional market risks only. The superior returns of hedge funds over the last decade is empirical evidence refuting the CAPM theory.
Furthermore, although the favorable composite returns of hedge funds are direct evidence that the underlying markets are not efficient, the returns across hedge funds are similarly evidence that the ability of hedge funds to earn a return is not efficient. The performance of individual hedge funds has varied dramatically, as Figure 1.2 shows.
In theory, a hedge fund's level of return should be directly related to its risk (intercepting at the risk-free rate). However, if you statistically analyze the relationship between the risk (measured as the annualized standard deviation of return) and return (measured as the compound annual return) of funds, you find, as in Figure 1.3, that the actual relationship is negatively sloping (versus the theoretical positive sloping relationship shown in Figure 1.1).
Although the negative relationship is not statistically significant ([R.sup.2] = 0.02), it clearly implies that the relationship between hedge fund risk and return is not efficient.
Risks in Hedge Funds versus Traditional Investments In 1530, Copernicus concluded that the planets circled the sun in a well-defined, systematic behavior, consequently the name "solar system." It took 150 more years for Isaac Newton to explain gravity, the force that caused this systematic behavior.
In the financial world there are equivalent natural forces that similarly cause systematic behavior. The fundamental equity and interest rate market movements represent forces that drive correlated behavior across stocks and bonds, respectively. This correlated behavior is captured in benchmarks, such as the S&P 500 Index. Furthermore, in the traditional investment world, managers are typically judged based on how similarly to these benchmarks they perform, generally measured as tracking error. Therefore, the behavior of individual long-only funds is consequently drawn to the behavior of their specific benchmark. For example, a small-cap value manager is typically measured against a small-cap value benchmark, such as the Russell 3000 value index, and will have a strong incentive to behave similarly to that benchmark, while attempting to beat it. However, in the absolute return world of alternative investments, no similar gravitational force exists, and, consequently, the behavior of individual hedge funds cannot be meaningfully explained by the behavior of indices.
In traditional investments, the vast majority of risk is explained through linear relationships to the relevant benchmarks. Because hedge funds, measured on absolute returns, generally target risks other than core market exposures, the performance behavior of hedge funds is highly complex. This is exacerbated by the fact that there is no force pulling returns to the norm of an index.
Alternative Investments [not equal to] Traditional Investments
The fact that the risks of traditional investments are both linear and additive permits you to analyze them using relatively simple approaches. The behavior of hedge funds is significantly more complex because of the following:
Idiosyncratic risk. The primary risk in a long-only, traditional fund is directional market risk. In contrast, hedge funds target "idiosyncratic" risk. "Idiosyncratic" is defined by Webster as "an individualizing characteristic or quality" or "individual hypersensitivity." For example, most long-only U.S. equity managers focus on a universe of 500 or 700 large-capitalization equities, with their greatest focus on the top 100 stocks because of cap- weighted bench-marks. Most hedge fund managers focus on a universe of more than 2,500 U.S. equities, with relatively equal focus on all market-cap ranges because their target is absolute return.
Relative value or spread relationships. Hedge funds often target relative value or spread relationships. They are able to target these specific relationships because of their ability to "go short" (sell a security they do not hold). Looking at Copernicus's view of the world, each planet goes around the sun in nice, uniform ellipses. This well-defined behavior is equivalent to the directional behavior of the equity market. Now consider the movement of Mars relative to Earth. These two planets have differently shaped ellipses that are not concentric and orbit the sun at different speeds. If you were to view the movement of Mars relative to Earth, the behavior would seem extremely irregular.
The relative behavior of spread trades in hedge funds is similarly irregular and idiosyncratic. For those of you who were not tracking the relative relationship in our solar system, Mars came within 56 million miles of Earth in August 2003, the closest it had been in 60,000 years (a 10-plus standard deviation event). Furthermore, astronomers tell us this will not occur again until August 28, 2287. Wouldn't it be nice if such relative relationships could be as precisely forecast in the financial world?
Optionality. Unlike traditional fund managers, hedge funds can buy or sell options. Unlike the linear behavior of stocks and bonds, options introduce "convexity" (nonlinear behavior) into the portfolio. As Chapter 3 discusses, optionality can introduce significant risk into the portfolio.
Let's briefly discuss the return behavior of an option, using a basic call option as an example. Suppose an investor held a call option on IBM, which was trading at $75 per share. Assume the option was at a strike price of $80. The holder of the option has the right but not the obligation to receive the underlying stock at the specified strike price at a specified expiration time. Therefore, if at the time of expiration IBM trades at less than $80 the call is "out of the money," and the option would be worthless. However, if IBM is trading for greater than $80 at expiration the option has value. If at the time the option expires IBM is trading at $85, the option would be worth $5, the premium over the $80 strike price. If IBM is trading at $100, the option would be worth $20 (again, the premium of $100 over the $80 strike price). Therefore, the option will have a "payout function" (the relationship between what the option is worth and the value of the underlying stock at expiration) as shown in Figure 1.4.
As you can see, the relationship is kinked, or "convex." Furthermore, the value of such a call option would be relatively small because the option is out of the money when IBM is trading at $75, so the risk exposure per dollar of capital is potentially extremely large. However, the value can increase rapidly (and dramatically as a percent of the price paid for the option) as it comes into the money. If you are long the option, this nonlinear behavior represents only upside. However, if you are short the option, this convexity can result in significant losses.
Beyond directly holding options, portfolios can hold positions with "embedded" options, cash instruments that are bundled with a related option. For example, convertible bonds are corporate bonds bundled with equity options. (Although traditional managers will invest in convertible bonds, they do not explicitly target the optionality as do hedge funds.)
Leverage. Hedge funds can use significant financial leverage by borrowing or using notionally funded instruments. (In contrast, mutual funds can use extremely limited leverage.) Although this does not introduce a new source of risk, it amplifies all the other risks. Chapter 3 discusses leverage in detail.
Asymmetric trading. Traditional investments are typically buy-and-hold strategies. The average holding period is generally a year or more. In contrast, many hedge funds execute trading-oriented strategies. The average holding period is typically one month, although it can be as short as a day. Hedge funds frequently follow asymmetric trading strategies. These strategies can often have option-like behavior (convexity) without actually holding option positions.
Asymmetric trading strategies introduce convexity, or option-like behavior, because the trading rules for holdings that are profitable are different from those that are not. In general, hedge funds hold profitable positions longer than unprofitable positions that are stopped out (closed out having hit a previously established limit). Such asymmetric trading strategies (discussed in Chapter 10) effectively create synthetic options, that is, funds that behave as if they contained options. As with options, when market-implied volatility increases, such a strategy HFRF Fig 1.5 tends to generate significant gains. Therefore, these strategies are equivalent to being "long volatility."
For example, trend-following commodity trading advisers (CTAs) employ quantitative trading systems that automatically respond to trends. These managers who trade in managed futures demonstrate "long-volatility" behavior. That is, they tend to generate favorable returns when equity volatility increase. Because equity volatility tend to increase when the underlying equity market falls, managed futures generally have positive returns when the returns of the equity markets tumble. Figure 1.5 shows that managed futures posted positive returns in fifteen of the eighteen periods of consecutive monthly declines of the S&P 500 that occurred since 1980.
Furthermore, unlike short sellers who also generate positive returns when the S&P declines (short sellers demonstrate linear behavior in the opposite direction of that of the market), the returns of CTAs demonstrate convexity, also posting positive returns during periods that the S&P increased (see Figure 1.6).
Event risk. Hedge funds take risks in event-driven strategies such as merger arbitrage, capital structure arbitrage, and distressed debt. Event-driven strategies are characterized by extreme price moves around key events.
Excerpted from Hedge Fund Risk Fundamentals by Richard Horwitz Copyright © 2004 by Risk Fundamentals LLC. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of ContentsForeword (Ramon Koss).Preface.Introduction.
Part One: The Components of Risk.
1 Volatility.Risks in Hedge Funds versus Traditional Investments.The Distribution of Hedge Fund Returns.Value at Risk (VAR).
2 Diversification.The Power of Diversification.Systematic Biases.Overdiversification.
3 Leverage.Financing Leverage.Borrowing Leverage.Notional Leverage.Unlevered Risk.Instrument Risk.Construction Leverage.What Is the Right Amount of Leverage?
4 Illiquidity.Planning in Case of Crisis.The Size Factor.Elements in an Escape Plan.The Cost of Illiquid Redemption Policies.Choosing among Alternatives.Calculating the Opportunity Cost of Illiquidity.
Part Two: Market Risk Management.
5 Measuring Risk.Sell-Side Heritage.Normal Market Behavior.Will History Repeat?Risk Measures Based on Actual Fund Returns.Risk Measures Based on Simulated Fund Returns.Crisis Market Behavior.
6 Understanding the Source of Risk.Slicing and Dicing or Bucketing.Index-Based Benchmarks.Value at Risk (VaR).Risk-Factor Framework.Marginal Risk Measures.
7 Risk Visualization and Articulation.Comparative Statistics.Risk Visualization Techniques.Communicating Risk in "Hedge-Speak".
8 Risk Culture.Integrating Risk Management into All Hedge Fund Processes.Style Drift versus Nimbleness.Personality Risks.Status Issues.Environment Issues.
Part Three: Other Risk Processes.
9 Non-Market Risk Management.Systems and Procedures.Organizational Issues.Disciplined Processes.
10 Constructing a Fund.Value Creation Levers.Shorting.Hedging.Overvalued Positions.Relative MisvaluationsIlliquid Securities.Leverage.Convexity.Nimbleness.Establishing a Basis in which to View the Construction.Balancing Risk and Return.
11 Performance Attribution.Assessing Primary Sources of Returns.Other Factors in Performance Attribution.
12 Risk Budgeting.Risk Budgeting Self-Assessment.Definition of Risk Budgeting.Formal Risk Budgeting.A Management Process, Not a Back-Office Tool.A Common Language.Managing Complex Causal Relationships.A Comprehensive and Integrated Approach.Integrated Systems Support the Process.How Formal Should Your Risk Management Be?
Part Four: Risk from the Investor's Viewpoint.
13 NAV/Return Reporting.Lack of Documentation.Inefficiencies.Incomplete Reporting.Lack of Precision.Misleading Measures.Masking Risk.Dressing Up Returns.
14 Constructing a Portfolio of Funds.Integrating Asset Allocation, Manager Selection, and PortfolioConstruction.Understand Manager Risks.Understand Your Objective.Adopt a Prospective Outlook.Focus on Marginal Risk and Return Measures.Construct the Portfolio Incrementally.Minimize Exposure to the Underlying Market.Manage Secondary Risk Exposures.Maximize Idiosyncratic Risks.Limit Offsetting Exposures.Diversify the Portfolio.Plan for the Worst.Consider Using Optimizers.
15 Risk Due Diligence.Analyzing Previous Portfolios.Determining Transparency and Risk Culture.
16 Transparency.Changing Investor Requirements.The Political Environment.The Pros and Cons of Position Disclosure.Current Practices.
Part Five: The Solution.
17 Industry Standard Solution.Reporting Standards—A Common Language.The Case for Standardization.
18 The Risk Fundamentals Solution.Overview of the Service.NAV/Return Reporting.The Risk Fundamentals System.The Risk Fundamentals Statistics.Distributed Solution.Standardization with Flexibility.Risk Budgeting Support.Effective Risk Communication.Interpreting Risk Management Reporting.Concentrations.Leverage.Liquidity.Risk Factors.Historical Simulation.Stress Tests.Convexity.Risk-Return Analyses.Constructing a Fund.Constructing a Portfolio of Funds.Performance Attribution.
What People are Saying About This
"A wonderfully written book on a topic that has vexed investorsand professionals alike--balancing the need to know against thedesire to provide information. In a thorough and comprehensivemanner, Richard Horwitz takes the reader on an explanatory journeythrough the risks associated with hedge fund investing. His insightand experience give him the perspective needed to articulate thechallenges faced by this industry, as well as offering a soundsolution that I believe couldn't come soon enough."—Andrew A KandiewManaging Director, Risk ManagementCommonfund
"Richard Horwitz has produced a work of exceptional practicalvalue. This book deals head-on with the challenges of hedge fundinvesting by providing intelligent, well-informed, and uniquelyaccessible advice. Most usefully, he provides a benchmark forhedge fund investors to evaluate their own investmentprocesses."—Andrew B. WeismanDirector of Risk Management and Research, Strativarius CapitalManagement, LP
"Required reading for anyone who wishes to understand thefine points of hedge fund risk measurement."—Steve McMenaminChairman, Greenwich Roundtable
"Not overly technical, this book is not only a must-readfor neophytes and the newly indoctrinated to risk on derivativesbut also a great refocuser for risk professionals!"—Robert M. AaronChairman and CEO, Derivatives Portfolio Management, LLCMember of the Board, Managed Funds Association"A comprehensive, eye-opening account on risk managementwhich should be read by investors and managers alike."—Lois PeltzPresident and CEO, Infovest21
"This book offers an excellent review of the complex topic ofhedge fund risk management. Furthermore, it provides aninnovative and pragmatic solution to the key transparencyissue."—Pierre Jette, MBA, CFAAssociate Vice President, Equity Markets, CDP Capital
"Richard Horwitz provides a invigoratingly fresh and engagingperspective on hedge funds, risk management and investingprinciples. Practitioners all too often forget the basic principlesof quantitative risk management, and thus obscure rather thanilluminate the trade off between risk and reward. This bookeloquently bridges the divide between the 'theory' and the'practice' of investing in hedge funds."—Adil AbdulaliDirector of Risk Management, Protégé Partners
Most Helpful Customer Reviews
Hedge funds are complex, risky investment vehicles. Other funds, such as most equity mutual funds, have straightforward investment strategies. By contrast, equity-oriented hedge funds may engage in various trading practices and investment strategies. They may be short funds, long-short funds or market neutral funds. And equity-oriented hedge funds are only a small sliver of the hedge fund universe. Thus, assessing the risk of hedge funds is a challenge. In language intelligible to most lay readers, author Richard Horwitz lays out the issues to consider when evaluating hedge fund risks. He has accomplished a great deal merely by writing this in readable prose, instead of in equations. He also explains his company's hedge fund risk measurement system. We believe every hedge fund manager and anyone who even thinks of investing in a hedge fund should read this book.