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P ARKER G LOBAL S TRATEGIES Risk Management For Hedge Fund Investors: Exploring the New State-of-The-Art Riskdata New York May 23, 2006 Virginia R. Parker,

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Presentation on theme: "P ARKER G LOBAL S TRATEGIES Risk Management For Hedge Fund Investors: Exploring the New State-of-The-Art Riskdata New York May 23, 2006 Virginia R. Parker,"— Presentation transcript:

1 P ARKER G LOBAL S TRATEGIES Risk Management For Hedge Fund Investors: Exploring the New State-of-The-Art Riskdata New York May 23, 2006 Virginia R. Parker, CFA

2 © 2006 Founded 1995, 15 professionals Specialist in designing and managing customized multi-manager hedge fund portfolios including global multi-strategy, global hedged equity, bond substitute, energy and natural resources, FX, portable alpha, green Advised on allocation of over $1.75 billion Risk oversight, estimated p/l’s and risk analytics available 24/7 with drill down capability via secured website Registered in the U.S. as RIA, CTA, CPO P ARKER G LOBAL S TRATEGIES, LLC PGS Overview

3 P ARKER G LOBAL S TRATEGIES, LLC What is Risk? “Risk is the link between investment of assets and the promise of return.”

4 P ARKER G LOBAL S TRATEGIES, LLC What is Risk? “Risk is the potential for loss of control and/or value. Risk may range from the benign to the malignant, from the dormant to the brewing to the exploding. Risk may be expected or it may be a surprise. Most importantly, risk is ever present.”

5 © 2006 Risks Involved in Hedge Funds Market Liquidity Leverage Concentration Hedge Ratios Short Volatility Style drift Currency Hedging Portfolio Risks P ARKER G LOBAL S TRATEGIES, LLC

6 © 2006 Counterparty Legal Credit Model Accounting Regulatory Clearing Human Fraud Operational Risks P ARKER G LOBAL S TRATEGIES, LLC Risks Involved in Hedge Funds

7 © 2006 Best Practices Approach to Risk Management Adhere to highest standards of implementation Independent of trading function Integrated across strategies Empowered to act Finger on the pulse of the market P ARKER G LOBAL S TRATEGIES, LLC

8 © 2006 Investor Risk Committee Investors have three primary objectives from disclosure: Risk Monitoring Risk Aggregation Across Entire Portfolio Strategy Drift Monitoring P ARKER G LOBAL S TRATEGIES, LLC

9 © 2006 Investor Risk Committee Full position disclosure does not always allow investors to achieve objectives and may compromise a hedge fund Summary of risk, return, and position information can be sufficient Evaluate information on four dimensions: –Content –Granularity –Frequency –Delay Reporting must be coupled with initial and ongoing due diligence reviews P ARKER G LOBAL S TRATEGIES, LLC

10 © 2006 Investor Risk Committee Reporting must be coupled with initial and ongoing due diligence reviews Market, credit, leverage, liquidity, and operational risk are interrelated and should be included in the discussions P ARKER G LOBAL S TRATEGIES, LLC

11 © 2006 Investor Risk Committee Content: the quality and sufficiency of coverage of manager’s activities including information about risk, returns, and positions on an actual and stress-tested basis. VaR can be useful, needs to be standardized Aggregate measures of a fund’s exposure to different assets Aggregate measures of geographical exposures NAV and stress measures of NAV Cash as a percent of equity Correlation to an appropriate benchmark Greeks Key spread relationships P ARKER G LOBAL S TRATEGIES, LLC

12 © 2006 Investor Risk Committee Granularity: the level of detail Larger funds may be more impacted by providing too much information Large funds need to guard against predatory trading Top 10 positions is useful, where it does not put investors’ interests at risk Alternatively, disclosure by asset class and region P ARKER G LOBAL S TRATEGIES, LLC

13 © 2006 Investor Risk Committee Frequency: how often the disclosure is made Monthly summary statistics Quarterly for less liquid strategies or slow turnover Performance attribution can be useful to disclose more frequently than risk attribution Daily p/l provided at month end for funds marked to market daily P ARKER G LOBAL S TRATEGIES, LLC

14 © 2006 Investor Risk Committee Delay: lag between holding period and disclosure Summary statistics should be disclosed as soon as possible (w/in 10 days of reporting period) Delay may be viewed as average holding period of strategy Disclosure may use generic rather than specific names if strategy is still active P ARKER G LOBAL S TRATEGIES, LLC

15 © 2006 We must constantly be aware of portfolio risk and operational risk: Choosing Measuring Monitoring Controlling Exposure P ARKER G LOBAL S TRATEGIES, LLC Control

16 © 2006 Policies and Procedures Middle Office Quantitative Models Strict Accounting Standards Strong Documentation Savvy Managers P ARKER G LOBAL S TRATEGIES, LLC Successful Risk Management

17 Judging The Quality of A Hedge Fund’s Performance Low Diversified Liquid Conventional Long Independent Strong Small High Concentrated Illiquid Esoteric Short Conflicted Weak Large Exposure to Market Value Portfolio Positions Strategy Optionality Pricing Price Discovery Market Impact P ARKER G LOBAL S TRATEGIES, LLC

18 © 2006 The Quantitative Tools Risk Measurement Must Be Tailored to the Strategy Value at Risk Contribution to Risk  Incremental Risk Gross Net Analysis (Beta-Adjusted) Sector  Country Stress Testing Key Drivers  Factor Analysis Scenario Analysis Monte Carlo  Recursive Models Downside Deviation Minimum Acceptable Return  Maximum Acceptable Loss P ARKER G LOBAL S TRATEGIES, LLC

19 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Sample VaR Track* *Based on 2 standard deviations

20 © 2006 Contribution to Risk Percentage Risk In Proportion to Total Risk - US Germany Based upon each country’s contribution to total value at risk. P ARKER G LOBAL S TRATEGIES, LLC Netherlands Italy Canada Australia Switzerland UK FranceJapan VaR  = additive VaR  = correlated Analyze highly correlated regions Net correlated VaR for Europe = 24%

21 Incremental Risk Portfolio Risk With Versus Without Manager A Manager B Manager E Manager D Manager C Total Portfolio A Key Driver A Risk Reducer A Diversifier with small risk A Risk Reducer It’s not allocation of equity capital; it’s allocation of VaR. P ARKER G LOBAL S TRATEGIES, LLC

22 Aggregate Portfolio Sector Exposure Report

23 P ARKER G LOBAL S TRATEGIES, LLC Equity Long/Short Sector Exposure Report (Beta-Adjusted) Financial Industrial Consumer, Non-Cyclical Consumer, Cyclical Communications Basic Materials Energy Technology Diversified Utilities GrossNet ShortLong

24 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Riskdata Analysis: Fund of Hedge Funds

25 P ARKER G LOBAL S TRATEGIES, LLC Number of constituent funds 12 + cash 95% VaR below the risk-free rate per month; annualizes at 4.8% Marginal contribution to VaR for the top five largest allocations Using Riskdata on the FoF level – Estimating VaR

26 P ARKER G LOBAL S TRATEGIES, LLC Estimating significant exposures on the FoF-level Market drivers bucketed in 12 types Only consider drivers that have a significance metric of at least 0.4 FoF is long equity as given by ‘North American Market’; up-beta 0.25% and down-beta 0.38% t ‘Health Care’ but since we have have position-level transparence, we know this is spurious The ‘next significant’ sector-driver is utilities and this is confirmed by the position- level information

27 P ARKER G LOBAL S TRATEGIES, LLC Estimating extreme exposures on the FoF-level For large moves, ie 1% tail moves in the underlying market drivers, the up- and down betas differ. The only significant types of drivers are still ‘Sector’ and ‘Equity’ The betas for the large up- and down moves conform with position-level information; the main ‘Sector’ driver is identified as ‘US utilities’ by the system

28 P ARKER G LOBAL S TRATEGIES, LLC Estimating the impact of historical market dislocations ‘Canned’ historical default scenarios provided by system; user can define own scenarios be assigning start- and end dates ‘ Impact’ on the FoF-level estimated by applying returns of the market-drivers to the aggregated up- and down betas (‘regular’ and ‘extreme’ as appropriate) for the periods of the dislocations

29 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Riskdata Analysis: Event Driven Hedge Fund

30 © 2006 Risks Involved in Hedge Funds P ARKER G LOBAL S TRATEGIES, LLC Manager A is Event-Driven - Opportunistic according to market environment - Has included distressed, merger arb, activist We have position level transparency and daily returns since investing PGS First invested in May 1998

31 © 2006 Sensitivity Profile – Event Driven Manager P ARKER G LOBAL S TRATEGIES, LLC Most recent 36 months ending April 10, 2006 Biggest factor exposures are sector, style, and cap size Manager has been < 50% US for past 18 months

32 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Extreme Sensitivity Profile – Event Driven Manager Highest sensitivities are equities and utilities Currently Manager is up 10% YTD through April Down 3.3% for May through the 19th

33 © 2006 Stress Events: Estimated v. Actual P ARKER G LOBAL S TRATEGIES, LLC

34 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Riskdata Analysis: Japanese Activist Fund

35 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Japanese Activist Fund

36 © 2006 P ARKER G LOBAL S TRATEGIES, LLC Japanese Activist Fund  With the exception of Main Japanese equities with the strength of 0.2, the analysis does not identify any significant sensitivity to other intuitive factors.  A positive sensitivity to Beta in both directions with a spread of (Gamma) suggests a marginally negative net market exposure. This also suggests the short book to be the main contributor of the portfolio returns.  A lack of appreciable strength to any of the major factors renders this manager un-explained by our Risk Data analysis.

37 © 2006 Risk Management is Action Prudent Actions Before Investing Establish Watch/Cut/Termination Levels Careful Due Diligence –independently verify reputation –understand what can go wrong with the strategy –examine the portfolio Thorough Review of All Documentation –offering memorandum –investment manager contract –subscription agreements –administrator and Auditing engagement letters –audits –client communications Diversify, Diversify, Diversify P ARKER G LOBAL S TRATEGIES, LLC

38 © 2006 Risk Management is Action After Investing Terminate a manager/redeem from a fund Require a manager to reduce exposure Independently overlay an offsetting hedge Remember, no action is an action P ARKER G LOBAL S TRATEGIES, LLC

39 Successful Hedge Fund Investing Requires: Diversification across strategies, managers, and factors Transparency to monitor style, risk, and performance measurement Quantitative risk measurement tools for objective, independent evaluation Accurate performance measurement to judge the quality of the return Ongoing due diligence – situations change over time P ARKER G LOBAL S TRATEGIES, LLC

40 P ARKER G LOBAL S TRATEGIES 1177 Summer Street Sixth Floor Stamford, CT Phone: (203) Fax: (203) © 2005


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