Amid Weak Returns, Hedge Funds Take Aim at Risk Management

In an effort to appease institutional investors, hedge funds are dedicating more resources to risk management and are working to ensure the independence of their risk managers, according to a study conducted by the Managed Funds Association, Bank of New York Mellon and HedgeMark.

The study, entitled "Risk Roadmap: Hedge Funds and Investors' Evolving Approach to Risk," was conducted by analyzing quantitative and qualitative data collected from chief risk officers of global hedge funds, institutional investors, and prime brokers. The data revealed an industry that's devoting more energy to improving best practices around risk management and transparency.

The results found that hedge funds expect 41 percent of investor reporting to happen on a daily or weekly basis five years from now, up from 22 percent today and 12 percent in 2007. It also revealed that 79 percent of hedge funds now separate their risk manager and fund manager functions to ensure independent oversight. Meanwhile, 60 percent of large hedge funds now have a dedicated risk management function, and 84 percent of all hedge funds now use off-the-shelf risk analytics in their portfolio management or trading systems, the survey said.

"Investors are increasingly taking a trust and verify approach to a hedge fund's reported risks and exposures," Orla Nallen, BNY Mellon's managing director of alternative investment services said. "As a result, hedge funds have augmented their reliance on independent, third-party administrators and will continue to do so."

Nallen also noted that a growing number of fund managers are turning to third-party administrators to not only beef up risk mitigation and transparency, but to also help them expand into new markets and satisfy regional regulatory reporting requirements.

"Risk has always been central to the investment process, but we are definitely seeing an increased focus on risk from both hedge fund managers and investors," said Andrew Lapkin, the president of HedgeMark, a firm that builds portfolio construction and risk monitoring tools. "For managers, it's about protecting against unexpected losses and ensuring that the risks being taken are being properly rewarded."

The research identified 14 types of risk that confront hedge funds and their investors, including liquidity, volatility and credit risk. That list also includes concerns like currency, commodity and so-called meta risk, which captures all the qualitative risks that can't be easily measured such as organizational behavior or moral hazard.

Nevertheless, this news comes with the hedge fund industry slogging its way through a second bad year in a row, with numerous indicators showing the sector is being badly outperformed by the U.S. stock market.

And although Advanced Trading has previously reported that investors like pension funds and endowments had been turning increasingly to alternative investments like hedge funds, there are signs that some investors are losing faith. SS&C's GlobeOp forward redemption indicator showed the number of investors looking to pull money out of hedge funds climbed to 3.34 percent in August , up from 2.18 percent in July and 2.71 percent during the year-earlier period.

Meanwhile Reuters reported last month that Citigroup yanked $410 million from John Paulson's hedge fund, while shares of Man Group , the world's largest publicly-traded hedge fund have plunged nearly 75 percent in the last year amid weak returns and client outflows.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio