The Challenge
The VaR systems of today are inadequate to the task of measuring the entire universe of risks faced by investors. When markets are calm and predictable, their assumptions can appear reasonable, sometimes even for years at a time. Under such conditions, if a hedge fund manages its VaR, then it has managed its risk, and, if a hedge fund reports its VaR, then it has satisfied the transparency needs of its investors.
However, when markets break down, as they have over the past year, previously hidden risks emerge. In such times, hedge funds realize that they are exposed to risks against which they felt insulated and investors discover that that they are uniformed about risks that they did not even know existed.
Certainly, VaR measures important components of risk, and, when considered together with security liquidity and portfolio leverage, captures the portion of risk for which investors are compensated. However, there also exists an entire universe of risks for which investors are uncompensated. Examples of these risks are:
- Counterparty risk
- Valuation risk
- Operational risk
- Business continuity risk
- Conflict of interest risk
- Fraud risk
- Compliance risk
Not only is there a broad range of risks, but, as the ongoing financial crisis continues to demonstrate, there are perverse interdependencies between varying forms of risk. As a result of this dynamic, risk must be managed on an integrated basis.
Significant barriers stand in the way of satisfying the compelling need for quality risk management and transparency. First, risk management at the vast majority of managers is not satisfactory. Risk is inherently complex, multidimensional, non-linear, and non-additive. Statistical risk management does not work well for many assets and instruments, especially the complex, illiquid, and opaque securities frequently held by hedge funds. Furthermore, established systems do not measure liquidity and leverage, the primary causes of hedge fund blow-ups. Many forms of risk are not managed in a disciplined way. Finally, different forms of risk (e.g., investment, counterparty, operational, valuation, and fraud) are managed in isolation.
Of significantly greater consequence than the weaknesses in risk management at individual funds are the sizable barriers to quality transparency and risk management for investors. Constituent traditional investments (equity, fixed income, and mutual funds) and alternative investments (hedge funds, CTAs, private equity, and real estate) all use different solutions. Even within hedge funds, different assets classes are generally managed in “silos” with specialized analytics.
Where provided, transparency reporting is not standardized so investors are unable to either compare managers or aggregate risk from multiple constituent investments. This problem is exacerbated by the fact that the myriad silo-focused risk systems available are proprietary and closed.
This deficiency in transparency has long plagued the industry. Long Term Capital Management (LTCM) blew up a full decade ago, in September 1998. As a result, a committee comprised of the Secretary of the Treasury and the chairs of the Board of the Federal Reserve, the SEC, and the CFTC decreed that hedge funds should “disclose additional, and more up-to-date, information to the public”. However, virtually no progress has been made, or acceptable solution emerged, over the past decade. We are now enmeshed in a global financial crisis of unprecedented magnitude in which the lack of transparency has been broadly recognized as the underlying culprit. As a result, in September 2008, hedge fund investors lost approximately $200 billion, more than 40 times the LTCM losses.
Over the last several years, regulators have been encouraging the hedge fund industry to solve the transparency problem. Last year, The President's Working Group in the US decreed that “investors should seek sufficient transparency and disclosure to assess and monitor the material risks of a hedge fund investment…satisfactory disclosure will include the information investors need to understand the material risks and assess the investment in the context of their overall portfolios.” The Hedge Fund Working Group in the UK has determined that “investors need a significant amount of information to make a well-founded investment decision.”
Given the severity of the current crisis, the issues, including transparency, have escalated from the policy-makers and regulators to the legislators. Continued inaction is no longer an option. The industry needs to proactively adopt a solution, or the newly empowered regulators will impose one. The paradigm of the past has been discounted, the solution for the future has arrived.
