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Operational Risk - June 16, 2005

An Interview with Stéphane Daul, Senior Quantitative Analyst at EIM

Stéphane Daul, PhD, who heads the quantitative risk management methods team at EIM, has recently joined the Edhec Risk and Asset Management Research Centre as a research associate. In this interview, he discusses the importance of cooperation between academics and practitioners in the area of hedge funds, the management of operational risks within funds of hedge funds, the key components of successful operational due diligence and the nature of his research with EDHEC.

Stéphane Daul

You have recently joined the Edhec Risk and Asset Management Research Centre. Why have you decided to take on this additional responsibility?

Stéphane Daul: The Edhec Risk and Asset Management Research Centre is a unique platform where academics and practitioners are brought together and provide an in-depth view of academic and industry research in the field of risk management and asset allocation for the buy-side, at a pan-European level. Specifically, the Centre has proven able to produce cutting-edge research on hedge funds by combining a high level academic approach with realistic solutions.

For EIM, having committed significant resources over the past two years to developing innovative quantitative approaches specifically adapted to the unique characteristics of hedge funds, it is therefore a great opportunity to share resources, research and thoughts with others at the centre and jointly improve the level of understanding of hedge fund operational risks, thereby supporting the hedge fund community at large.

This cooperation is the perfect demonstration of academics and practitioners devoting a substantial amount of time and effort to link research with industry realities in order to deliver innovative, but applicable solutions to a fast evolving industry.

Being responsible for the quantitative risk management methods within your firm, what are for you the main elements funds of hedge funds should focus on?

Stéphane Daul: Funds of hedge funds select and blend the best managers by understanding how they go about implementing their often very sophisticated strategies, and investing with those which seem to have a clear edge in sourcing and executing trades, because of their particular talent, experience, models, etc.

This requires an assessment both of a manager’s ability to spot and capture opportunities in the marketplace, and of his ability to identify and manage associated risks. The risks which immediately come to mind are, of course, the market risks to which a particular strategy is exposed. But past research clearly suggests that operational weaknesses cause easily as much trouble for hedge funds as do market stresses.

Assuming a yearly failure rate of 0.6%(1) and a portfolio of 25 hedge funds with independent default risk, we see that the risk of having at least one default in a year is 13.9%. In an equally weighted portfolio this would mean 13.9% probability of losing at least 4%. Further a key finding of the study(1) is that operational risk greatly exceeds the risk related to the investment strategy, with at least 56% of the hedge fund collapses directly related to a failure of one or several operational processes.

Without discounting the importance of financial risks in the manager selection process, understanding, measuring and mitigating operational risks for which the investor receives no premium represents today one of the most important challenge funds of hedge funds are facing.

So, what are the critical elements funds of hedge funds should consider while developing an approach to mitigating exposure to operational risks?

Stéphane Daul: Operational risk is often perceived as something essentially administrative in nature, which can be circumscribed by ensuring that a limited number of formal procedural safeguards have been put in place at the hedge fund and are operating properly.

As a result, many fund-of-fund companies have a small, specialized team of persons, usually with an administrative background, who perform operational due-diligence independently of the research function.

Our experience has been that operational risks cannot be evaluated properly without due consideration to the specific trading approach of the fund. Consequently, investors should fully integrate operational due-diligence as a core component of the standard due-diligence procedure. In each manager review, in addition to the analysts reviewing strategy-specific risks, one analyst should specifically be assigned to cover operational risks.

The analysts assigned to the operational portion of the due-diligence reviews should be specialized to some extent, in that their backgrounds would typically include experience in prime-brokerage or audit, but in all cases, they should be active members of the research team, with extensive experience as qualitative analysts and a very detailed understanding of the strategies pursued by the funds they review.

Can you describe the infrastructure required to satisfy this requirement?

Stéphane Daul: Thorough operational-due diligence must focus on three distinct parts: risks associated with the specific investment strategy of the fund, risks associated with the administrative tasks carried out by the fund and its interactions with counterparties, and finally risks associated with the legal structure and documentation of the fund. This can only be achieved by ensuring the close collaboration of a team comprising a diverse set of skills.

In our view, at least four different analyst visits to a hedge fund are required before a fair assessment of all risks involved can be made, and therefore the investment authorized. As described earlier, one of those at least will have specialized knowledge relating to the assessment of operational risk.

Operational Reviews have to support a very structured set of conclusions which form an integral part of the due-diligence report and recommendation on the basis which an investment committee can make an investment decision. The most complex element in this process remains the quantification of operational risks which, by nature, is most easily analyzed by qualitative means. At the end of the day, the investment committee will have to decide whether these operational risks outweight or not the benefits of investing in a given fund.

The quantification of operational risks starts with the elaboration of a robust, transparent, repeatable and concise methodology that will allow operational risks in various funds to be compared. More advanced quantitative modeling approaches are still maturing within research teams.

What are the main directions of the research you are starting with Edhec?

Stéphane Daul: We will first analyze the reality of operational risk in hedge funds by focusing on hedge fund bankruptcies resulting from non-financial causes since mid 90’s. The result will be an inventory of all operational losses and their sources during the past 10 years. For example, a first categorization can be made based on whether or not the cause of the failure was fraudulent(1). We will also construct the universe of available hedge funds in each of these years.

On these data we will then apply actuarial techniques to come up with a first model or the frequency and severity of such events. A typical model for the frequency would be a Poisson process, while the severity showing tail risks could be captured by a Pareto distribution. The combined distribution is then obtained using an aggregation algorithm. After concentrating on the individual hedge funds we will develop a copula capturing the failure dependency between two or more funds. Such copula can then be used to explicitly incorporate the notion of operational risk diversification within broader diversification models.

Finally, a more conceptual approach based on causal models of the fund’s organization will be taken. This approach should provide a systematic measure of operational risks. We will identify the high-risk events that need to be explained, identify the relevant risk factors and quantify the relationship between them. The robustness of the resulting model will then be tested using our database.

Stéphane Daul joined EIM in January of 2004 and heads the quantitative risk management methods team. He received a Ph.D. in Theoretical Physics from the University of Fribourg, Switzerland in 1997. After working as a professor and researcher in theoretical physics, Stéphane joined the Swiss Reinsurance Company in 2001 where he was in charge of the development of statistical methods for group risk modelling. Stéphane is also a CFA charterholder.

Founded in 1992, EIM is a leading provider of customized fund-of-hedge-fund solutions, constructed either as stand-alone portfolios or tailored to enhance the risk-adjusted return profile of its clients’ existing asset mix. EIM has over US$ 6.5 billion in discretionary mandates, and a staff of 150 located in New York, London, Paris, Nyon (near Geneva), Zurich, Gibraltar, Monaco, and Tokyo. EIM’s approach blends rigorous, structured, ISO-certified due-diligence, selection and portfolio management processes with innovative quantitative risk management methods, specifically adapted to the unique characteristics of hedge funds.

(1)Jean-René Giraud, The Management of Hedge Funds’ Operational Risks, EDHEC, April 2004.