Guide to Hedge Fund Risk Management

“We worry top-down. But invest bottom-up”

-Seth Klarman

Why You Need a Risk System

When we ask fundamentally-driven hedge fund managers about the risk system they use to manage factor exposures, the usual response is a soured expression followed by, “VaR is a meaningless hack.” Many managers mistake a VaR number calculated from monthly returns in a spreadsheet for a risk system. Let’s get one thing straight off the bat: VaR is not synonymous with risk. In fact, any attempt to boil down the complicated concept of risk to one single metric is a fool’s hope and provides only false comfort. In today’s complex and interconnected world, risk is not a single number but a multi-faceted and evolving concept. The first step managers must take is to stop thinking of their portfolio as a collection of independent bets, but rather as a small piece of the overall market. A risk system must, at the very least, help managers think along those lines. In this post, we’ll talk about the basic needs that such a system must address, and the initial steps managers should take to lay a solid foundation for risk management.

Worry Top-Down

For a manager trained to find hidden risk and intrinsic value within companies, worrying about top-down risk is not second nature. They’re fantastic at analyzing balance sheets and investing in securities that beat benchmarks and sizing their bets (we call that position sizing skill), but when asked about their exposure to momentum or how their portfolio would react to a rate hike, they often scratch their heads. It’s fine to ignore that if you’re Warren Buffet, but if you have less than infinite investment horizons and investors who scrutinize your monthly returns, a more serious approach to measuring and managing risk is in order. But where do you start? A risk system’s number one goal is to help the manager answer real-world questions about possible and likely scenarios.

To Start, Ask Simple Questions

How would your portfolio react to a Lehman default scenario? What about a rate hike? A war? What if the equity markets were to sell off 20%? Are you short quality and long junk? Is the long book overly dependent on momentum? These questions are not for quants, they’re very much fair game to ask of any portfolio manager—and a good risk system should make it simple for the manager to answer. This is the first step.

To help our clients answer these questions, we built a visual system based on a multi-factor model, complex behind the scenes, simple on the surface. For this post, we use a fake L/S hedge fund portfolio that looks and behaves like a real one. Here are the portfolio’s largest risks as it stands today.

We can see that a repeat of 9/11 would result in the highest immediate draw for the portfolio. Looking to the right we can see the external factors that would contribute the most pain, and those that would help.

If you wanted to get a little more specific, you might want to tweak the 9/11 scenario to reflect your view of a similar event. Let’s say that you want to see what happens if there is an attack, but the price of oil goes up, not down. For that, we built an intuitive equalizer, similar to the one found in your audio system, allowing you to tweak factors and see the effects in real time.

Selecting 9/11 on the drop down calibrates the equalizer to the actual historical scenario’s effect on each factor. Now, you can use the slider to nudge oil higher, effectively creating your own custom scenario. The result is interesting. If a 9/11-like event were to occur but the price of oil were to rise, the negative effect on your portfolio would be partially offset by the rise in oil, and the total expected loss would be lower:

Dig a Little Deeper

Now that we understand our overall factor exposures, what can we do about them? A good system will make it seamless to move from risk measurement to risk management by showing the manager exactly where the risk is coming from. For instance, in the modified 9/11 scenario we created above, we see that most of the draw can be expected to come from the portfolio’s net exposure to the market. Below, we list the securities that contribute most to this factor, sorting the table on Market. Cutting the weight of top risk-contributing securities would effectively decrease exposure to the factor:

Provide Historical Context

We mentioned that risk is an evolving concept—your portfolio today is different than it was a few months ago. To capture this, we show our clients the evolution of factor exposure in their portfolio and how the changes they made transformed their risk profile. Here are the most prominent risk factors acting on the portfolio over time (contribution of factors on the first chart). We can see the growing presence of momentum and a short value factor (factor exposures on the lower chart).

In following posts on risk management, we’ll cover more advanced topics such as breaking VaR bands, measuring individual security sensitivities, understanding risks by category (multi-grouping) and tracking the efficacy of your risk models.