Institutional investors in the hedge fund world are buzzing about a new report by five large hedge funds discussing how hedge fund managers can get better control over risk.
"Any efforts in this area are welcome," said Jeff Landle, head of alternative investments for The Commonfund Group, Wilton, Conn. "As the investor base becomes more institutional, this kind of thing will continue."
The report, "Sound Practices for Hedge Fund Managers," was developed by Caxton Corp., Kingdon Capital Management LLC, Moore Capital Management Inc., Soros Fund Management LLC, all of New York, and Tudor Investment Corp., Greenwich, Conn. Each of the firms has more than $3 billion under management.
It suggests ways in which hedge funds can better control the various risks they face, but it does not call for mandatory government regulation or self-regulation of the industry.
The website on which the report was posted Feb. 7 -- www.hfmsoundpractices.com -- had more than 1,000 hits in four days, and the report also has been posted on the websites of several hedge fund news and performance reporting services.
"It's the first time risk management has been looked at from a `sound practices' view from the manager side of the industry," said Kenneth Raisler, a partner in law firm Sullivan & Cromwell, New York, which worked with the firms to put the report together.
"They (those who did the study) are looking at it from the point of view of the risk takers," he added. It's important that this report "comes from a different perspective," that of the hedge funds themselves, as opposed to committees from different areas, including the government. Mr. Raisler said there's also been a lot of interest in the report from accounting firms that "want to distribute it to their institutional investor clients."
It's a business
"The biggest thing this report does is that it shows that many of the firms involved in this business think of it as a business," said Mark Yusko, chief investment officer of the University of North Carolina, Chapel Hill, which has a $730 million endowment. "It's a well thought-out, put together document," he added, "which shows that the companies in the (hedge fund) industry are thinking about things like risk management and compliance that are important to institutional investors."
"I think it's a very good idea," said Jay Yoder, director of investments at Vassar College, which has a $638 million endowment, with $81 million invested in hedge funds. Referring to the report's suggestions on what hedge funds can do to manage risk and leverage, he said, "if the industry can do a successful job of self-regulating, it's much less likely the government will step in with heavy-handed or misguided regulations."
The report says hedge fund managers should perform stress tests to determine how potential changes in market conditions could affect the market risk of the portfolio.
Mr. Raisler said two other key areas of the report are the way it looks at liquidity risk -- "the risk of a drain on liquidity because of losses in the market and customer redemptions" -- and the way it examines leverage and its effects.
According to the report, "funding liquidity is critical to a hedge fund manager's ability to continue trading in times of stress . . . Adequate funding liquidity gives a hedge fund manager the ability to continue a trading strategy without being forced to liquidate assets when losses arise."
The report recommends ways in which hedge fund managers can strengthen portfolio stability during periods of market stress, including effectively assessing and managing funding liquidity. In particular it says hedge fund managers should be able to quantify a hedge fund's cash and borrowing capacity relative to the risk in its portfolio and anticipate collateral requirements of creditors and the likelihood of investor redemptions, putting in place contingency plans when they're appropriate.
Looking at leverage, the report said "hedge fund managers must recognize that leverage is important, not in and of itself, but because of the impact it can have on market risk, credit risk and liquidity risk -- i.e., that leverage influences the rapidity of changes in the value of the portfolio due to changes in market risk, credit risk or liquidity risk factors."
The most relevant measures of leverage are "risk-based" ones that "relate the riskiness of a portfolio to the ability of the fund to absorb that risk," the report said.
To emphasize the point, the report said "hedge fund managers should develop and monitor several measures of leverage, recognizing that leverage, appropriately defined, can magnify the effect of changes in market, credit or liquidity risk factors on the value of the portfolio and can adversely impact a fund's liquidity."
In terms of disclosure and reporting requirements, the report suggested hedge fund managers provide periodic reports to creditors and counterparties that provide information about a fund's risk and return profile, including performance, risk and liquidity measures.