Risk Management Framework for Hedge Funds

September 18, 2012 · READ

A recent study suggests hedge fund managers are beginning to prioritize risk management as part of their business processes. There are a number of reasons they are doing this, but the overall motive is clear – investing money into other ventures is always an uncertain proposition, which makes hedge funds an inherently risky business.

That said, hedge fund managers can’t be afraid of risk, as it is essential for maximizing returns. Among American companies, the risk is often viewed as negative, with a risky investment perceived as one that shouldn’t be undertaken. Hedge fund risk management policies can’t be built around that preconception, or else managers will be missing out on key opportunities.

A whitepaper written by several hedge fund industry experts, called “Best Practices for the Hedge Fund Industry,” notes that the goal of risk management should not be the complete elimination of risk from investment decisions, but the better mitigation of it.

“A manager should establish a comprehensive and integrated risk management framework that is suited to the size, portfolio management process, and investment strategies of its funds,” the report adds. “Through the risk management framework, the manager should identify the risks inherent in its chosen investment strategies, and measure and monitor its exposure to these risks to be consistent with the manager’s intended risk profile.”

Establishing a Risk Management Framework for Hedge Funds

The whitepaper recommends five steps that hedge fund managers should take to establish a risk management framework that will enable them to capitalize on opportunities and avoid costly mistakes.

1. The identification of any and all material risks to which portfolios may be susceptible.

2. Measurement of the principal categories of risk, which could range from market and operational risk to leverage and liquidity risk.

3. Establishment of regular risk monitoring practices, with regard to the size of the fund, portfolio management processes, and the complexity of investment strategies.

4. The implementation of policies and procedures that establish measurement and monitoring of criteria.

5. The deployment of knowledgeable personnel to identify and manage risk, as determined by the policies and procedures put into place.

Risk management is important to hedge funds, but it’s also crucial that managers don’t view risks as threats. By deploying risk management strategies that can evaluate both threats and opportunities, hedge funds will be able to better capitalize on their investments and generate a greater ROI.


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