HF Operational Risk - A systematic approach
Jean-René Giraud
By their very nature, hedge funds allow the investor to be exposed to different risk factors such as volatility, counterparty, or liquidity risk, since this exposure is considered to be a source of superior returns for invested funds. As an example, it is well understood and widely accepted that market makers receive a premium (the spread) when acting as liquidity providers in a market. When hedge funds implement trading strategies that provide liquidity to a specific market (such as fixed income arbitrage, distressed securities or securities involved in an M&A process), part of the return that can be expected is a premium for the liquidity risk they carry when holding illiquid instruments that are potentially subject to large price swings.
Exposure to these risk factors is not only a source of superior return but also the very essence of hedge funds’ extensive diversification possibilities compared with traditional investments1. More importantly, it is interesting to note that the exposure to these risk factors is also a diversifiable risk as it has been demonstrated that hedge funds exhibit low correlations amongst themselves2.
These advantages do not come without a downside. Gaining exposure to alternative risk factors usually requires trading activities that can be considered less conventional than in the long only universe. These include investments in illiquid instruments, extremely high portfolio turnovers and non-vanilla OTC contracts. While these technicalities do not themselves represent an issue (the trading techniques of hedge funds usually originate at the desks of proprietary trading dealing rooms), they do however carry a level of operational risk for which the investor receives no premium.
With an average of approximately 15 fund collapses per year 3 out of a universe of a few thousand funds open to investment, it becomes clear that the risks related to the operational weaknesses of hedge funds significantly outweigh the levels of financial risk, which are usually the focus of the managers’ attention and investors’ concerns.
While few funds fail purely because of an operational problem (such as a terrorist attack, a system breakdown or the loss of a key member of staff), it is easily understood that a weak operational environment will increase the impact of an external event such as tough trading conditions or brutal changes in financing conditions. As an example, while fraud is rarely the initial intention of a hedge fund manager, the complexity of the support infrastructure inherent in the trading activity, as well as the lack of maturity of the industry, provide many opportunities for operational risks that can only be mitigated by an appropriate and professional due diligence process on the investment pools.
In this working paper, we first examine the reality of hedge fund operational risk and try to provide a first segmentation of the various risk factors underlying hedge fund operational infrastructure. We then describe what could be considered as a state-of-the-art operational due diligence approach focusing on the operational weaknesses of the funds. We finally investigate some advanced methods that can be used to quantify further the levels of operational risks.
References
1 See Agarwal and Naik (2000) or Schneeweis and Spurgin (2000).
2 See M.W. Peskin, M.S. Urias, S.I. Anjilvel, B.E. Boudreau; “Why Hedge Funds Make Sense” (Morgan Stanley Dean Witter, November 2000).
3 Source: Edhec Risk and Asset Management Research Centre, based on publicly available information only
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