Risk management policies are a growing topic of discussion in businesses throughout the world, particularly in the financial services sector. Firms that are involved in the management of other parties’ assets or the lending of funds to other parties have a unique need for individuals with a risk management certification. Hedge funds are a great example of entities that utilize risk management policies; to not only control internal operations but also as a marketing offering to entice new investors.
“What are hedge funds, exactly?” You have probably asked yourself this question at least once in your life. Sure, we read about them in the newspaper and/or online. We hear about them on television and how some people are making millions of dollars by managing them. But what are they? What do they consist of? Are they just another scam or can you really build a consistent, livable income from them?
By definition, a hedge fund is a portfolio of aggressive investments that utilize extremely advanced investment strategies such as long, short, leveraged and derivative positions in all markets – in an effort to generate high returns.
-Still confused? That’s because the aforementioned explanation could mean just about anything.
If we do a little more digging, we will find that most hedge fund managers today, take on the role of risk managers, investment bankers, venture capitalists and currency speculators.
Many financial services make use of a well-structured risk management policy to manage their day-to-day exposure to risk, including exclusive investment entities such as hedge funds. For many years hedge funds were considered the high-stakes bad boys of the investing world; an image that the industry despised and rejected in the public eye. Over the past few years the hedge fund community has stepped up their efforts to shed the negativity and weariness that is often associated with them. Of course in some ways this “risky market gambler” perception was always unfounded, especially considering hedge funds use complex strategies and investment vehicles to hedge away systemic and market risk.
Due to their size and unique capital structure, hedge funds were previously allowed to operate outside the stringent oversight of investment regulators, but this has changed over the past decade. While hedge funds continue to abstain from using the comprehensive risk management ‘best-practices’ of other financial services such as banks and large fund managers, they have certainly increased their use of risk management policies. These processes have evolved to monitor not only how their range of investments mitigate inherent market risk for their investors, but also how they conduct their business in general.
The organizational risk philosophy at any particular hedge fund typically reflects the interest-level and commitment of that fund’s top traders and officials. The greater these managers believe in not chasing greater return at the expense of risk compliance, the stronger the fund’s risk policy is embedded throughout the entire fund’s other personnel. Many hedge funds now employ a Chief Risk Officer and have doubled their expenditures on risk management processes and risk compliance. They are increasingly seeking individuals who have obtained at least one risk management certification, focusing on credit and financial risk. These changes are the result of not only clearer minds within the hedge fund management community, but also from changing investor expectations. While hedge funds have always used complex quantitative risk management models to quell investor fears, most managers will tell you that in the past few investors know, or cared to know, how they worked. While this sentiment has not dramatically changed during these past few months, there are changing expectations from investors, especially large institutional money managers, in regards to transparency, risk analysis processes, and how business is conducted. Fund managers typically benefit from long investment time-horizons and leeway from their investors, but even traditionally ‘sticky’ investors are demonstrating a willingness to pull assets out of hedge funds if managers do not comply with the changing risk expectations.
As a consequence of the 2008 financial upheaval the fund community has witnessed the creation of a series of private oversight groups, such as the ‘Hedge Fund Standards Board’. These self-regulatory bodies are creating industry benchmarks and best-practices in risk management, and from which the community can develop their own risk policies.
Hedge funds of all sizes have developed and incorporated risk management policies into their operational and trading strategies. These processes include limits on acceptable losses per trader, controls and limits on the types of investments made, and formal communication and internal policing procedures. These funds offer limited transparency on how they conduct business to anyone outside their inner circle of investors, and thus individual firms are expected to internally police themselves. A predominant precursor of risk in this business is the overuse of leverage, and risk management in this area has become a hot-button issue within the fund community. Many fund managers use borrowed money (funds borrowed against the assets provided by their investors) to maximize the return on their positions, and achieve the above-market gains the industry is famous for. However, this practice leaves the firm and its investors assets exposed to unforeseen market risks. The majority of funds now have risk assessment policies in place that monitor their liabilities-to-assets ratios and prevent individual traders from exceeding leverage limits.
Due diligence in many aspects of the hedge fund business has increased since the 2008 financial crisis. Fund managers are now acutely mindful of their brokerage trading connections, as well as the structure of asset-custody with transaction partners. Since the 2008 financial crisis hedge funds have learned the hard way that counter-party risks certainly do exist in the financial services sector, and the domino effect resulting from the collapse of Lehman Brothers demonstrated that even the best and brightest can be left exposed.
Jason B Rhodes holds a BBA from Bishop’s University in Quebec, Canada. Jason completed post-graduate course risk in Risk Management at Columbia University in NY. With 20+ years in the Financial Services and Hedge Fund industry, Jason provides market risk oversight on equity capital markets as well as regulatory reporting advisory services. He was employed as the Senior Risk Analyst at one of the largest Hedge Fund management firms in the world. He then assumed the role of Managing Director, Risk Reporting and Measurement for a firm specializing in Risk Management and Regulatory Reporting.