UNDERSTANDING RISKS EMBEDDED IN PORTFOLIOS OF HEDGE FUNDS
Arabadjiev does us all a great favor by choosing the word “understanding” for the title of his contribution. He explains the importance to investors of appreciating the qualitative factors that circumscribe the quantitative task of evaluating hedge fund risks.
It doesn’t matter if there is a well established theory for the optimization of asset allocation, when an investor does not have access to the essential asset return information necessary to apply the theory.
Arabadjiev takes us through the frequently discussed risks of hedge fund investing, investment risk, operational risk, liquidity risk, and business risk, looking behind the standard methodologies. We find that understanding is the result of a process that takes as inputs the parameter estimates from models, not a process that ends with the production of those estimates.
From this perspective, Arabadjiev provides his thoughts on achieving understanding (if, alas, not inner peace). For example, he notes that even if an investor does not have the systems and resources necessary to effectively use position level information from a hedge fund to measure risk and performance, the position information is still valuable in service of the investor’s need to monitor strategy drift.
When I meet with hedge fund investors, I emphasize the importance of understanding both the risk management culture and the extent of risk management processes over the importance of the level of fund VaR or the geographic distribution of the fund’s risk at a particular date. The result of this understanding is a vastly improved employment of the tools of quantitative risk analysis and the improved use of the results of those quantitative tools.
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- Brown, S.J., W.N. Goetzmann, and R.G. Ibbotson, 1999, "Offshore Hedge Funds: Survival and Performance 1989-95," Journal of Business 72(1), 91-117.
- Capco, 2003, Understanding and Mitigating Operational Risk in Hedge Fund Investments
- Fung, W., and D. A. Hsieh, 1997, "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds", Review of Financial Studies, 14, pp. 313-41.
- Ineichen, A., 2000, In Search of Alpha, (London: UBS Warburg).
- Parker, V. R., 2000, Managing Hedge Fund Risk: From the Seat of a Practitioner (London: Risk Books).
- Schneeweis, T. and T. Spurgin, 1998, "Multifactor Analysis of Hedge Funds, Managed Futures, and Mutual Fund Return and Risk Characteristics", Journal of Alternative Investments 2, pp. 1-24.
- Tremont's TASS Asset Flow Report, 2003.
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ERRATA AND OTHER MATERIAL
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