Wednesday, September 05, 2012

Report on Hedge Funds and Risk Management Issued by Industry Association and Global Financial Services Firm

Against the backdrop of radical change in the landscape of hedge funds and risk management, not to mention the advent of derivatives, the Managed Funds Association and BNY Mellon, a global financial services company, have issued a report outlining a number of best practices. The report noted that the SEC is poised to implement the JOBS Act and adopt regulations removing the Regulation D ban on general solicitation for private funds. The report said that this change could encourage more publicly-accessible fund websites and allow fund managers to be more candid and forthcoming when engaging with media on risk management  practices and information. Moreover, the report predicts that the erection of Dodd-Frank mandated derivatives exchanges should spur marked improvements in the data available for exposure and risk analysis.

The report urges hedge funds to invest in risk management as a required business practice and not as an optional expense. Risk management functions should be separated from the investment and due diligence functions. The position of Chief Risk Officer should be created with compensation that it not performance-based, recommended the report, but that is substantial enough to provide an incentive to do the job properly. Disclosure of risk and exposures to investors would be an excellent way to mitigate investor concerns about investing in a hedge fund. Risk disclosure should be granular, meaningful and frequent. Concomitantly, investors could be educated about hedge fund risks.

Transparency has improved, noted the report, but getting independent and high frequency reporting on risk and exposures is still not the norm. Trusting a manager is one thing, said the report, since trust is important to any business relationship, but validating this relationship through position-level analytics of exposures and  risk should be seen as the only prudent and effective path going forward. 

With regard to operational risk, the report noted improvement in managing counterparty credit risk by detailed knowledge of counterparty quality. In addition, ratings, equity prices, credit spreads, and data integrity are more fully appreciated by managers and investors alike. In particular, there has been recognition of the limitations of certain risk and industry assumptions. The research indicated that diversification is being used as the best method to mitigate counterparty risk, since the financial condition of a counterparty can seemingly change virtually overnight.   Manager’s intentions are to avoid high concentrations in a single counterparty since few believe that any institution is immune from periods of systemic and non-systemic volatility, contagion, and risk. There are some instances where managers and investors may seek to hedge counterparty risk with derivatives.