Liquidity Risk in the Bond Markets

According to an article in the March 21 edition of Pensions & Investments, hedge fund strategies focused on bonds such as relative value and long/short credit are facing increased liquidity risk due to unintended consequences of regulations such as Dodd-Frank and Basel III.  This is especially true in the junk bond arena.  The legislation closed the proprietary trading desks of the banks and increased capital reserve levels have caused a liquidity crunch.  In the past, the proprietary trading desks were the primary trading counterparties for hedge funds.  Some funds that have closed include Claren Road Asset Management, Third Avenue Focused Credit Fund, and Lutetium Capital.

Fund managers have responded in a variety of ways.  They have traded in smaller amounts, reduced their leverage and expanded their counterparties.  According to Aaron Dalrymple, head of credit at Cliffwater, smaller transactions of $5 million in capital are easier now.  There has been some outreach to pension funds and endowments as new trading partners, either directly or through a dark pool in Liquidnet.

Until the liquidity issue is resolved, firms are scaling down or closing credit strategies.  Investors have agreed.  In the second half of 2015, alternative investment data provided eVestment stated that there was no demand for credit strategies.

Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.

Effects of Pension Risk Transfer on Fund Managers

In the largest pension risk transfer deal of all time, General Motors offloaded $26 billion in pension liabilities to Prudential in exchange for $29 billion in assets.  This plan was executed in two stages.  First, a lump sum settlement was offered to 42,000 retirees which are about 33% of the entire beneficiaries.  For the rest of them, their pensions would be covered by annuities bought from Prudential.  The deal was created with help from Morgan Stanley, State Street and Oliver Wyman.  Other large corporations seeking to follow in General Motors’ footsteps are Alcatel-Lucent, Verizon, Ford and United Technologies.

With the rise of defined contribution plans like 401K’s, corporations have reduced or terminated their defined benefits plans.  Since 1975, the number had dropped from 250,000 to less than 30,000 – and 33% were frozen.  At the same time, pension funds have been reducing their risk profile by reducing their asset allocation to equities, doing buy-in deals (buying annuities to hold on their balance sheet) or buy-outs (doing a General Motors type of deal).  The giant deal is a harbinger of things to come.  In a survey of 500 global companies, Aon Hewitt discovered the following pension planning:

• 35% will offer lump sums to beneficiaries
• 6% will buy annuities to cover their payouts
• 6% will transfer their plan
• 4% will terminate their pension plan

Of the insurance companies involved in pension risk transfer, only Prudential and MetLife are able to take on General Motors-like transactions.  There is capacity to handle approximately $100 billion in pensions and General Motors has taken $26 billion of it.  Besides the big two, other firms that are participating in the business include MassMutual, Principal, American General and Mutual of Omaha.  Non-insurance companies such as JC Flowers and private equity firms are also targeting US companies.

These transactions may change the game in the financial services sector.  Asset managers of pension funds will lose assets to the insurers.  Managers specializing in long duration bond, liability driven investing, ETFs and alternative managers will gain.  So will consultants in risk transfer:  Aon Hewitt, Mercer and Towers Watson.  Corporate pensions currently hold twenty percent of US stocks.  As these assets are sold in exchange for bonds, there will be secular weakness in the stock market.  From a government point of view, the Pension Benefit Guaranty Corporation (PBGC) will be under pressure as only healthy pensions can transfer their risk, leaving underfunded pensions to be insured.

The source for this posting is the September 2012 article of ai-CIO.com.

Longevity Swaps: A New Product for Pension Funds

Pensions & Investments reported that more and more funds in the United Kingdom are using longevity swap trades to hedge their pension payout risk. This product was first traded in 2009 and, in 2011, had a notional amount of $10.7 billion in contracts traded. Pension funds are guarding against retirees living longer than their actuarial predictions where they would be responsible for extra payments. The companies selling this risk include insurance companies such as Swiss Re, Prudential Financial Incorporated and Legal & General Group and investment banks such as Goldman Sachs, Deutsche Bank, JP Morgan Chase and Credit Suisse.

The swap trades are easier for pension funds to execute than other hedging vehicles known as buy-ins or buy-outs. These transactions also transfer the pension payout risk but need large upfront payments. Sometimes, the institutions have to sell assets to afford the payments.

The source for this artivle can be found here.

Regulated Hedge Funds: UCITS and Mutual Funds

SEI published a white paper on the growth of alternative investments called Regulated Alternative Funds: The New Conventional.  Because of the credit crisis of 2008 and the current Eurozone crisis, more and more investors have clamoring to be able to invest in alternative investments to lower downside volatility and offer returns uncorrelated with long-only mutual funds. In the first 8 months of 2011, $61 billion flowed into these investments. $22 billion (39% of all investment capital) were invested UCITS funds. There are now more than 1,500 UCITS funds managing $254 billion. $39 billion were invested through US mutual funds and ETFs. They now compose 4.4% of mutual fund assets and are growing at a 17% rate since 2007 when they were 2.2% of mutual fund assets. There are approximately 730 of them with 118 launched in 2011. Mutual fund families such as Ategris, BlackRock, PIMCO, Nuveen and First Eagle have funds that invest in traditional hedge fund strategies such as managed futures, long/short, credit, commodities, arbitrage and absolute return fixed income.

Internationally, they are constructed in an evolving vehicle known as Undertaking for Collective Investment in Transferable Securities (UCITS). Success has brought on investors. There are established funds with good returns, transparent investment and risk management strategies, and strong brands. The largest fund is the Standard Life Investments Global Absolute Return Strategies with $13.6 billion in assets under management. Other large funds include Julius Baer BF Absolute Return, Newton Real Return, JP Morgan Income Opportunity and PIMCO GIS Unconstrained Bond.

Within the US, they are launched within mutual fund families and ETFs. The largest are, in order of size, the SPR Gold Shares ETF, PIMCO Commodity Real Return Strategy, Ivy Asset Strategy, and iShares Silver and Gold Trusts. For investors, both structures offer more transparent risk management, liquidity, counter party diversification and limits on leverage. Investors are seeking better returns, lower volatility and to protect capital. Mutual fund families are aggressively marketing to and educating investors and registered investment advisors through white papers, instructional videos, fact sheets, regulatory filings and road shows.

Mutual funds are seeking to increase their fee structure. Alternative asset managers are seeking to have a more varied investor base.

When new products are launched, rules are reviewed. They are on the third iteration for UCITS. In the US, the SEC has stopped approving new funds and ETFs to review the effects of derivatives on portfolios. Within Europe, Luxembourg and Ireland are expecting to conform with UCITS regulations with the bonus of having additional flexibility. This may make them preferable to certain investment strategies and investors.

Demand is growing from sovereign wealth and national pension funds in Asia, Latin America and the Middle East and US institutional, high net worth and retail investors.

Rogue Trader Strikes UBS for $2.3 Billion Trading Loss

Another rogue trader struck the investment banking world last week.  This time the firm is UBS;  the loss is more than $2 billion;  and the trader is Kweku Adoboli.  This is the biggest loss since Societe Generale lost $7 billion in 2008 with Jerome Kerviel.  The accused trader worked as a director trading ETFs on a desk named Delta One.  The details are not clear but the trades seem to be in index futures on the Standard & Poor's 500, the DAX in Germany and the Euro Stoxx 50.  As in the Kerviel case, false trades were entered into the system to evade the bank's risk management levels.

UBS has had a history of one-off losses.  There was their $1 billion investment in Long Term Capital Management in 1998.  Dillon Read Capital Management, one of their hedge funds, lost 150 million francs in 2007 before it was shuttered.  In 2008, $50 billion in losses on subprime mortgage securities caused the resignations of CEO Marcel Ospel, Finance chief Clive Standish and Investment Banking Head Huw Jenkins.  There are people pressing for the resignation of the current CEO Oswald Grubel.  He had become CEO in 2009 and was reforming the bank's risk management.

The sources for this article can be accessed at Bloomberg.com, the Telegraph, Reuters, the New York Times Dealbook and Business sections.

Risks to Monitor in Structured Finance

Investors of CDOs must note the risks involved in such instruments.  Many were brought to light during the credit crisis in 2008.  They are:

• Default risk of the underlying collateral - This is greater for the equity tranches.
• Financial engineering risk - In 2008, the subprime mortgages, which were the underlying assets of the CDOs, began to default.  This caused most of the CDO tranches to suffer a drawdown.
• Downgrade risk - The credit raters, Standard & Poor's, Moody's and Fitch's may reduce the rating of the CDO tranches.
• CDO default rates - In a one year period in 2008, more than 4,000 CDO securities worth $351 billion were downgraded or defaulted.
• Differences in periodicity - The frequency of interest payments from the collateral may not match the payments on the CDO securities.
• Difference in payment dates - The interest payment schedule from the collateral may not match the payment schedule on the CDO securities.
• Basis risk - The risk when interest payments are calculated on the underlying assets of the CDO based on a different index than the payments on the CDO securities.
• Spread compression - When credit spreads become lower and result in reduced interest payments from the underlying collateral.
• Yield curve risk - Any yield curve shifts or changes in steepness affect CDOs if their underlying assets have different maturity dates.

Credit Derivatives: Some Basic Information

In prior posts, we have looked at credit default swaps.  Let's take step back and look at credit derivatives as a whole.  They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure).  Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit.  Previously, they would have to hold the underlying assets in their portfolio which is capital intensive.  To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness.  He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.

What is credit risk?  There are three components:  default, downgrade and credit spread.  Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full.  A loan is in default if a scheduled payment is not made.  Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt.  Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt.  Credit risk is usually measured by rating agencies or using the credit spread.

What are the underlying / reference assets that credit derivatives are used for?  They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds.  These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries.  They have a high exposure to large declines in prices.  High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's).  Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate).  LIBOR is the interest rate at which banks borrow from other banks in London.  In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance.  This is call risk.  There are to types of loans - revolvers and term loans.  Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings.  Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates.  In addition to credit risk, emerging markets debt is exposed to political risk.  Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.

Options, futures and forwards are known as binary options.  They are similar to equity options.  If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder.  A credit-linked note is a bond with an embedded credit option.  These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge.  The referenced asset is either a corporation or a basket of credit risks.

A total return credit swap allows an investor to rent a balance sheet.  The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread.    The seller of the swap retains ownership of the asset.  For example, an investor could be positive on Apple bonds.  A swap can be bought on the returns of Apple bonds.  The buyer would receive that return and pay the seller LIBOR plus a spread.  The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.

Risk Management: Some Basics

Dr. Philippe Jorion of the University of California at Irvine and Managing Director of Pacific Alternative Asset Management Company (PAAMCO) wrote a main portion of the risk management overview for the CAIA Level II curriculum.  There are market, credit, liquidity, regulatory and counterparty risks.

Market risk is the risk of loss in financial market prices.  It is also called systematic risk.  To calculate market risk, all the assets in the portfolio should be used to find the possible profits and losses by using market data.  The most well-known model is value at risk (VaR).  This allows for tracking of any drift in investing style, hidden risks and of new fund managers, markets and assets.

Credit risk is the risk that a counterparty to a contract does not fulfill its obligation by not paying the amount or not delivering the asset owed.

Liquidity risk occurs when an investor cannot sell assets.  There are two types:  funding and asset.  Funding liquidity risk happens when investors redeem their capital from a fund, when loans from the prime broker are not renewed or during margin calls.  In these situations, the fund may be forced to sell assets to raise capital.  Asset liquidity risk is the risk of losses due to the price impact of forced asset sales.  These risks can be mitigated by matching the investment horizon of an investor's assets and liabilities, putting in place a lock-up period when an investor cannot redeem their capital, having a notice period before redeeming capital, creating gates to limit withdrawals to a percentage of capital and suspending redemptions altogether.

Regulatory risk is the risk that government or regulatory agencies may change the financial rules such as imposing short stock trades during the credit crisis of 2008.

Counterparty risk is almost the same as credit risk except it includes the counterparties of your counterparty.

We will be examining other topics from Dr. Jorion's writings in later posts.  The source for this article can be found here.

Protecting a Portfolio Against Inflation

I was directed to a research report written by AllianceBernstein about how an investor can prevent inflation from eating into real returns for a target date fund.  Target date funds are a relatively new asset allocation product that adjusts the percentages of each asset during the length of the investment.  This is called the glide path.  The asset mix is higher for riskier assets (i.e. equities) early.  As time goes by, the asset mix becomes more conservative with a heavier weighting in bonds as the fund approaches its target date.  Although the paper was written for target date funds specifically, it can be applied to any traditional portfolio.

Spikes in inflation can be considered a rare tail risk event (three times since World War I).  When it happens, they reduce the value of investment portfolios considerably.  Once the spike is identified as such, buying any protection skyrockets.  The addition of real assets can serve as a hedge against this event.

AllianceBernstein considers three factors when analyzing hedges:  sensitivity to inflation, reliability and cost-effectiveness.  The sensitivity is how an asset reacts to inflation.  Equities has a -2.4 sensitivity.  When inflation is up 1%, equities fall 2.4%.  20 Year Treasury bonds have a -3.1 sensitivity.  Treasury Inflation Protected Securities (TIPS) have a sensitivity of 0.3 to 0.8, depending on the duration of the bond.  Commodity futures have a sensitivity of 6.5.  The second factor, reliability, tells how often the sensitivity factor is correct.  For example, commodity futures have a reliability factor of 54%.  When inflation rises, then the futures may rise but it only does so half the time.  The chart shows that TIPS are the most reliable, then commodity stocks, REITS and commodity futures.  Buying these assets have an opportunity cost.  The investor is giving up returns to buy this insurance against inflation.

Here is a list of hedging assets:

• Equities - natural resource and real estate sectors
• Commodity futures
• Currency forwards
• Real Estate
• Gold
• Short term bonds
• TIPS

The report recommends a portfolio of commodity futures, equities and currency forwards.  The weight depends on the lifecycle of the investor.  Of the investor is still working, it should be about 5%-15%.  At retirement, 15%-35%.  After 10 years of retirement, 30%-50%.

Gaia Capital: A Lesson in Tail Risk Management

Gaia Capital, one of the larger hedge funds with $150 million in assets under management invested in Japan, has lost 75% of its assets after the earthquake, tsunami and nuclear power plant crisis.  At the end of March, the fund had $92 million in assets.  There was $32 million at the end of April due to losses and investor redemptions.  Gaia had been successful in prior years, returning 36.1% in 2009 and 21.7% in 2010 but it all unraveled after the natural disaster.  The losses were in derivative strategies such as swaps and put options.  The fund had placed a bet that the Japanese market would remain in a trading range i.e. they were short volatility.  As a result of the earthquake, the Japanese index, Nikkei 225, fell to 8,234.6.  The expected trading range was between 9,500 to 11,000.  Investors fled.  When the fund tried to exit its positions, there was no liquidity.  Gaia had to liquidate its positions at the bottom of the market.

Shorting volatility is exposed to event and/or tail risk.  A large downward move in the market causes large losses for the fund.

For more details, the source for the post can be accessed here.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

Advantages of a Fund of Hedge Funds

In a post earlier this month, I referred to a survey by the InvestHedge Billion Dollar FOHF Club which stated that there were inflows in the latter half of 2010 for funds of hedge funds.  The main disadvantage of funds of funds versus a hedge fund is the additional layer of management and incentive fees.  Average fees are 1% - 2% of assets under management, 0.5% for custodians and other services and performance fees of 20%.  The hurdle rate when the incentive fees are activated is around 10%.  The fund of funds managers are sometimes able to reduce the fees paid out to their investment managers because they have a large amount of liquid capital.

Here are the main advantages for fund of funds:

• Risk management - Diversification by investment strategy and the portfolios of the hedge funds
• Transparency and regulation - Better reporting on portfolio holdings, commentary from fund managers and documentation
• Minimum investment is lower - Allow access to multiple hedge funds at a lower capital level
• Access to closed funds - Hedge fund managers may allow fund of funds to invest in their closed funds because the fund of funds is a long term investor, has a good relationship with the manager or is a current investor.
• Liquidity - Monthly
• Portfolio management and monitoring - fund of funds manager invests in different funds, does due diligence and monitors funds for performance, risk and strategy

The source for this article is a Fund of Hedge Funds: An Introduction to Multi-manager Fund by Martin Fothergill and Carolyn Coke of Deutsche Bank.

Managed Futures: Risk Management

Since the credit crisis, fund managers have put more emphasis on managing their funds' risks.  The following managed futures article by Attain Capital lists the various methods of how Commodity Trading Advisors do this and diversify their investments.

• Money management - involves budgeting risks across different futures markets;  done by balancing the equity at risk for each trade
• Market selection - ensuring the position is liquid or using exchange traded futures to minimize counterparty risk
• Market diversification - investing in multiple, uncorrelated markets;  diversifying trades over different sectors or contract maturities
• Model diversification - using multiple trading models within the fund
• Timeframe diversification - creating trading models based on different timeframes
• Trade structure - using options to limit risk such as buying put options or spread trades
• Delta neutral - using spread trades to limit volatility
• Manager skill - using the manager's judgment;  this flexibility comes with a higher risk of large losses

Risk Measurement for Managed Futures Funds

There are five main types of risk management formulas that apply to managed futures funds.  Each has their limitations and caveats.  They also are separate measures.   They are:

• Margin-to-equity ratio:  This is the initial margin (in cash or Treasury bills) needed to establish the portfolio divided by the amount invested.  A low percentage means high leverage.  This may be misleading as the manager may have long and short positions or may be trading across different exchanges.
• Capital at risk:  When managers add a position, they attach a stop-loss rule to limit their losses.  This ratio calculates the total of the portfolio's losses if each position triggers the rules and divides it by the amount invested.  This is not an exact number because of the terms of the stop-loss rule.  The rule begins a transaction when the price is hit.  In a extremely volatile market, the actual trade price may be very different from the stop-loss price.  Capital at risk also does not account for offsetting long and short positions.
• Value at risk:  The potential loss for a given period and confidence level.  For example, a 95% one month figure of $10 implies that the portfolio has a 5% chance of losing more than $10 and 95% of losing less than $10.  Since the credit crisis of 2008, this has been the subject of some papers as measuring tail risk inadequately.  This is because the calculation is based on a normal distribution.
• Maximum drawdown:  This figure calculates the largest percentage loss for an investor for a specific period.
• Stress test:  This calculates a portfolio's losses by running different scenarios on the individual holdings to determine the effects on each scenario.

List of 10 Hedge Fund Risks

I was alerted to an interesting article written by Stuart Fieldhouse and Hans-Olov Bornemann of SEB Asset Management.  They listed the 10 mistakes to avoid with hedge fund managers.  They are:

• Fraud / misrepresentation - stealing from investors, assigning high valuations to illiquid assets
• Operational risk - counterparty risk, NAV calculations, key personnel leaving
• Concentration risk - too many assets in one sector, country or asset class
• Leverage - net and gross
• Liquidity risk - not being able to sell assets when needed
• Funding risk - mismatching borrowing and asset maturity dates
• Too many assets under management - not all managers can handle an increase in money
• Copycats - other managers following the same strategy
• Being front run - other funds trading ahead of a large fund
• Forced unwinding - funds may be forced to sell assets to make margin calls and client redemptions

Illiquidity Risk

I saw an article in the CAIA newsletter this month regarding Asset Allocation and Illiquidity Risk by Hossein Khazemi, Program Director.  Compared to previous posts, this is a slightly advanced idea.  Khazemi writes:
"Liquidity represents the ability of an entity to fund future investment opportunities and to meet obligations as they come due, without incurring unacceptable losses. If there are mismatches between the maturity of an entity's assets and liabilities, the entity is exposed to illiquidity risk."  He writes later about the Yale model of asset allocation created by David Swensen.  Swensen has written Unconventional Success:  A Fundamental Approach to Personal Investment and Pioneering Portfolio Management:  An Unconventional Approach to Institutional Investment.

The article can be accessed here.

Happy New Year to everyone!  Best wishes for a great 2011.