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Background

Hedge funds are collective investment vehicles fast becoming popular with high net worth individuals as well as institutional investors. These are funds that are often established with a special legal status that allows their investment managers a free hand to use derivatives, short sell, and exploit leverage to raise returns and cushion risk. Given that that they have substantial latitude to invest, it is instructive to examine the performance of hedge funds compared to other forms of managed funds.

hedge fund comic

How complex?

Given the complexity of hedge fund investments, meaningful analytical methods are required to provide greater risk transparency and performance reporting. Hedge fund performance is also beset by a number of practical issues generating “practical risks”. These risks are not fully addressed by the usual risk-adjusted performance measures in the literature. A penalty function to discount these extraneous risk dimensions is proposed. The paper concludes that further empirical work is required to provide informative statistics about the risk and return of hedge funds.

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Risk Assessment

Hedge funds are risky. But getting beyond that bromide and evaluating the prospects of a particular fund means understanding everything from internal operations to investors’ incentives to counter party and market conditions. Hedge Fund Investors from most of the countries are required to be qualified investors who are assumed to be aware of the investment risks, and accept these risks due to the potentially large returns available. Hedge Fund managers also employ extensive strategies of risk management for protecting the hedge fund investors which is expected to be diligently since the hedge fund manager is also a major stakeholder in the particular hedge fund. Funds may also appoint a “risk officer” who will assess and manage the risks but will not be involved in the Trading activities of the fund or employing strategies such as formal portfolio risk models.

Some of them are stated below:

1 – Regulatory and Transparency
2 – Investment Risks
3 – Concentration Risk
4 – Performance Issues
5 – Rising Fees & Prime Broker Dynamism
6 – Mismatch or Incomplete Information
7 – Taxation
8 – Problem of Plenty

Portfolio risk management for hedge funds goes well beyond traditional risk-management tools.  E.g. mean-variance analysis, beta, value-at-risk (VAR) etc . While these measures can be helpful under certain circumstances, they do not capture well the risk exposures of most hedge funds.

Conclusion

The ultimate goal of effective risk management is to eliminate or partly mitigate the potential tail risk events.  They are equivalent to a portfolio’s positions moving more than three standard deviations from its current price.

Effective risk-management practices should help improve hedge fund managers’ understanding. Also, they should know how changes in the financial environment would affect their fund’s performance.  And, ultimately, help them to perform better during volatile market environments and extreme negative financial events.

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