“It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move.”
–Grandmaster Alexander Kotov — inscribed on gift chess set given by Amaranth hedge fund.
The growth and maturation of the industry has led hedge funds increasingly to build independent risk management functions, which existed only in only a few multi-billion dollar shops a few years ago. This has been driven on several fronts. As larger hedge funds have grown, they have become mainstream financial institutions. Investors, particularly institutional investors, have increasingly placed emphasis on the function. Finally, recent market volatility has made such functionality increasingly necessary.
The following discussion focuses on proper governance structure for risk management in a hedge fund. An initial response might be that this is well understood. While there is a large body of literature describing how to quantify hedge fund risk and understand performance, there is little written on the function itself and how it can add value. It may be argued that the role is identical at a bank, and hence any business plan carries over. While there are similarities between risk management at a bank and a hedge fund, the roles at the two institutions exhibit differences.
First, regulatory reporting and audit is a significant part of the risk management function at a bank. This requires being staffed to cover many exams. Also regulators like model validation hence the need for modeling of all securities while in a hedge fund, marks are obtained from dealers.
Second, in a bank there is emphasis on risk reporting, portfolio policing, and monitoring. The risk reporting burden in a bank is an aggregation issue which is a costly difficult function for a large player with multiple businesses. Hedge funds on the other hand are not regulated and are in smaller set of businesses.
Third, bank organizational structure separates risk and trading reporting lines to ensure risk independence. In practice things are not as straight forward. The institutional power of a trading desk, which derives from many factors, including p&l history and internal relationships, greatly enhances the ability to override risk manager dissent, regardless of the nominal reporting lines. At a hedge fund, however, there are rarely such illusions. The Chief Risk Officer (CRO), typically reports directly to the chief investment officer (CIO) or owner, and so in absence of a culture for open discussion, dissent with portfolio risk takes a whole different venue.
Fourth, at banks risk is often not involved proactively in investment, portfolio construction, and hedging decisions because of the potential conflict of interest that may exist with the primary regulatory compliance obligation.
Fifth, an important component of hedge fund risk management is communication. This includes external communication to investors and counterparties, something that is not nearly as important at a bank.
Given the outlined differences, hedge fund risk role needs…