Hedge Fund Risk Management
- Defining risk.
- Successful risk management allows portfolios to continue compounding continuously.
- Best practices for managing risk include, “trading limits, stress testing, liquidity analysis, backtesting, and an understanding of leverage.”
- Use of tactics such as trading envelopes, stop losses, hedging, and buying put options.
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Investopedia states, “a hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.”
According to Oxford Languages, the definition of the word tautology, is as follows, “the saying of the same thing twice in different words, generally considered to be a fault of style.”
The phrase “hedge fund risk management” may seem redundant given the definition of “hedge”. Forgive us for the redundancy, however, as this topic is important. This concept is at the core of what hedge fund investing is about.
There are many, distinct risk management strategies and tactics employed within the investment world and often the method for doing so is the secret sauce which can give a hedge fund its edge.
But what is risk?
The answer may not be as simple as it seems!
According to Investopedia, “risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return.” Investopedia also states, “in finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.”
Ray Dalio, the founder of the hedge fund Bridgewater, has said, “When thinking about risk, please think about both the volatility risk and the risk that our assumptions are wrong.”
Cliff Asness, of AQR Capital Management, has a similar assessment on the concept of risk in that, “there are many who say that such ‘quant’ measures as volatility are flawed and that the real definition of risk is the chance of losing money that you won’t get back (a permanent loss of capital).”
The permanent loss of capital is possibly one of the easiest ways to think about risk. Take it from famed investor, Warren Buffet, whose first two rules of investing are: "Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One."
However, let’s circle back to the original definition of risk, “the chance that an outcome or investment’s actual gains will differ from an expected outcome or return.” It can be argued that the loss of capital is a result of risk, not the risk itself.
In our piece on Volatility, we wrote, “To some managers, volatility in terms of price movement is paramount. They do not care about root causes but use volatility as a signal to take down [exposure to markets] and sell their positions. For others, identifying key risks helps investors hedge out specific risks, avoiding volatility in their portfolio altogether while firmly holding onto their positions.”
As a form of risk management, some asset managers are happy to sell down positions at the first sight of volatility. Others maintain their positions, but hedge using more complex instruments that allow managers to remain fully invested with the goal of reducing risk.
Why Hedge Fund Risk Management May Help Lead to Better Investment Outcomes
So, we have established a few definitions of risk, but why is this concept so important? Warren Buffett says whatever you do, don’t lose money. And while this may sound like common sense, we have also heard the saying “No risk, no reward.” So how are we to decide what to do?
Why don’t we as investment professionals not just invest in an S&P 500 Index Fund and call it a day?
One reason is that risk can manifest in the market as volatility. While there may be false alarms along the way, the 2020 COVID market crash showed how drastically the market can move in the face of risk. This type of volatility can get in the way of compounding.
“Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Compounding can thus be construed as interest on interest”
Successful risk management allows portfolios to continue compounding continuously.
Are tails getting "fatter"?
In Nassim Taleb’s book, The Black Swan, he attributes faulty investment models to the use of normal distributions to measure the return and volatility of asset prices. Yet, markets do not move according to predictable statistical designs. Markets have fat tails, which imply losses happen more often and are larger than a normal distribution would suggest. Avoiding these losses through risk management allows portfolios to compound.
Merging Dalio and Buffett’s definition, Taleb’s protégé Mark Spitznagel, the CIO of Universa Investments, calls these downside moves a volatility tax.
The volatility tax is the hidden tax on an investment portfolio caused by the negative compounding of large investment losses.
By recognizing that volatility sets back a portfolio’s ability to compound, we get to the crux of the issue. Losses imply that a portfolio has retraced from its previous high. And by simply not losing money the portfolio would instead preserve capital and enable it to grow further.
This is typically the goal of hedge fund risk management: Preserving capital, managing downside risk, and generating alpha.
How do Hedge Funds think about Risk Management?
Rob Mirsky, the Head of Deloitte’s UK Hedge Fund practice, states that some of the best practices for managing risk include, “trading limits, stress testing, liquidity analysis, backtesting, and an understanding of leverage.”
Trading Limits: Trading limits are relatively straightforward. By limiting the size of positions, investors can take solace that no single position, industry, or factor will ruin their performance.
Stress Testing: Stress testing is another way funds can manage risk. Essentially, it means to be aware of what can go wrong ahead of time so that you are ready to act. Rob Mirsky of Delloite wrote, “In order to enable a firm to be more proactive in monitoring and mitigating risks in the portfolio, stress testing should include not only extreme movements but also changes that are only slightly greater than the norm in order to determine where thresholds or trigger points may be that would signal an adjustment in the portfolio.”
Liquidity, Leverage: Liquidity and leverage go hand in hand. Managing these risks is multifaceted as this can refer to monitoring the liquidity available to and leverage used by the fund, but also in the market more broadly. In addition to their own liquidity needs, funds want to make sure that when they liquidate a position there is a large liquid market for the asset they are selling so they can get the optimal price.
As shown by the recent Evergrande saga in China, once everyone tries to sell something at once, liquidity dries up until much lower prices. That’s why a steady move lower in the bond’s price suddenly cascaded.
Source: Business Insider
Tactics used in Hedge Fund Risk Management
As the previous section shows, there are multiple ways hedge funds can think about their portfolios in order to manage risk. But hedge funds also need to be ready and willing to act throughout the course of a trading day when markets are moving.
Trading Envelope: Shown below is a trading envelope. The orange line is a moving average, which can be calculated by using the trading price over a certain period of time. Popular durations are 50 and 200 trading days of data to calculate the moving average. The upward and lower bounds from the range shown below are referred to as an envelope. When an asset trades above the top envelope, a fund may deduce that there is limited short-term upside and sell their asset to take down risk. Alternatively, they could buy some at the low end of the range to take on more risk, deducing that the asset may not have much short-term downside.
Stop-losses: When using this tactic, investors choose a level of losses they find acceptable when either making a trade or an investment. When this level of loss on a mark-to-market basis occurs, the hedge fund manager would sell off the position. The hedge fund manager can always re-evaluate the position and put it back on, but by setting a position loss limit, the manager can be honest with herself ahead of time about what tolerance for losses/pain she has.
Hedging: There are multiple ways to hedge. One example is long/short investing. Hypothetically, if one thought Netflix’s stock was overvalued, they could short the stock. If they wanted to hedge themselves against being wrong, they could go buy Disney’s stock since the company has a large video streaming component to their business. This way, the investor is not short video streaming, but short Netflix specifically.
Put Options: Put options are bets that an asset will go down in value. A hedge fund manager may be long specific stocks but recognize that they are susceptible to systemic risk. In this scenario, the manager could buy put options on the stock market more broadly, to hedge out systemic risks like COVID.
Hedge funds are generally in the business of managing risk. That’s why “hedge fund risk management” is a tautological statement. The goal of risk management is to aid in compounding wealth, to enable portfolios to continuously earn returns instead of nursing large losses. In this sense, a good defense is the best form of offense.
There are many ways to manage risk. One can diversify. One can increase or decrease exposure to the market, and/or use complex hedging instruments.
Once managers have a handle on what risks they are exposed to, they can use whatever tactics suit their style and strategy the best. This could mean hedging a short position with a long one, using stop-losses, or adding and subtracting one’s risk with the aid of a trading envelope. Mark Spitznagel stated in his research on the Volatility Tax, “The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”
Well-managed portfolios seek to compound returns over time. While there is no way to eliminate risk entirely, hedge fund risk management can play an important role in helping ensure that a portfolio is well-managed.