A sophisticated hedge fund due diligence framework should assess all applicable risks – not only their non-quantifiable segment. Our proprietary due diligence routine includes evaluation of the complete range of risk categories: Market, Credit, Event, Liquidity, Volatility, Concentration, Strategy, Currency, Operational, Legal and Fraud risks.
Market Risk encompasses the uncertainty of future returns deriving from fluctuations in asset prices. In other words, if a portfolio consists of instruments that are subject to price changes, underlying price fluctuations result in portfolio value changes. By analyzing those changes over a given period we can measure the related risk. Over the last few years the VaR has become the most common measure of market risk.
Credit Risk refers to changes in value caused by possible credit events including upgrades or downgrades in obligor credit quality and defaults. Commonly, credit risk is associated with strict underwriting standards, limit enforcement and counterparty monitoring, thus focusing more on the qualitative framework. However, in the late 90s, credit risk has become the key concern of institutions due to an increasing amount of complex credit instruments. Therefore, a few methodologies of measuring credit risks have emerged. Probably, the most common approach to quantify credit risks refers to the VaR statement, which captures both rating change and default risks.
Event Risk arises because of inability of a financial instrument to withstand severe market conditions or extreme events. Common risk statistics can estimate risks during normal market conditions, but become largely useless to predict risks during unexpected crises resulting in extreme market shocks. To address this issue, proper Stress Testing techniques should be applied on a regular basis to both single instruments and investment portfolios.
Liquidity Risk involves the inability of a firm to fund its illiquid assets. Liquidity risk is an emerging topic in the financial risk world. Liquidity risk is directly linked with credit and market risks, which become uncontrollable because of delayed redemptions. In contrasts with market or credit risks, liquidity risk may result not only in a decrease of the portfolio value, but could also jeopardize the investor's own credit rating. In other words, if a fund is unable to fulfi ll a redemption request as agreed, the investor, in turn, may fail to fulfill his own credit commitments. The liquidity issues also indirectly affect market and/or credit risks of the portfolio as those become uncontrollable during the uncertain redemption period.
Volatility Risk refers to the impact on a portfolio of the unexpected changes in volatility. On the one hand, volatility risk involves changes in derivatives' prices due to the unpredictable changes in the volatility of the underlying assets. In that respect, only derivatives are exposed to volatility risk. On the other hand, some trading strategies show diverse performance during different volatility cycles, even though derivatives are not presented in the portfolio. Sometimes hardly explainable, this phenomenon has to be taken into account when analyzing hedge fund performance. A strong correlation with market volatility can be used for forecasting the future performance.
Concentration Risk arises because of increased exposure to one trading strategy or a group of correlated funds. Commonly, concentration risk is understood as exposure to a linked group of assets, for example, by location, by industry etc., while the actual correlation factor is ignored. When analyzing an individual hedge fund, concentration risk implies exposure to the underlying securities, while, for a FoHF, concentration refers to the strategy allocation. The primary reason to control concentration risk is to avoid an excessive correlation between assets or strategies. Therefore, a naive approach of addressing concentration risk by defining the strategy exposure limits is most questionable unless the underlying correlations are considered.
Strategy Risk implies changes in the employed trading strategies, which, in turn, leads to increased risks of other categories, for example, market or credit. Strategy risk refers to the style drift, which reflects change in the driving market factors. Typically, the style drift is expressed by a chart, which plots the factor weights over a given period, i.e., rolling factors' breakdown. By itself, the style drift is not necessarily a negative sign. The risks derived from style fluctuations involve the two following issues. First, the unexpected style drift may signal either staff changes or a weak trading strategy itself. Second, the style drift may lead to an excessive exposure to the market factors, which involve an increasing amount of credit or market risks. While the style drift can be easily quantified, it seems hardly possible to define the rules for the "good" and "bad" style drifts. Each fund needs an individual assessment taking into account not only the economic factor composition, but also their diverse impacts under the current market conditions.
Currency Risk arises because of various currency exposure across the constituent assets. Typically, this issue occurs, if the fund's units are denominated in one currency, whereas its underlying investments - in another. Any changes of the exchange rates lead to the NAV changes, even though the underlying prices remain the same. The common solution to avoid currency risk is to employ some currency hedging strategy, for example, by purchasing (or selling) forward contracts. Thus, the primary objective to assess currency risk ads up to examining the manager's hedging techniques, i.e., duration of the contracts, exposure to currency derivatives, a coverage of positions and so on.
Operational Risk results from errors that can be made in instructing payments or settling transactions. In practice, all institutions are exposed to it, while the sources are ample and diverse. Operational risk, unlike credit or market risk, does not yet have a universally accepted definition. Several groups, including the International Swaps and Derivatives Association, the British Bankers' Association, and the Basle Committee on Banking Supervision, describe it as "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events (Culp, 2001)." This definition includes legal risk but excludes strategic, reputational, and systemic risk. However, some banks define operational risk as all risk not categorized as credit or market risk, or as the risk of loss arising from human or technological error (Basle Committee, 1999). In general, operational risk includes the four key elements: people risk, technology risk, process risk, and strategic risk.
Legal Risk refers to the risk of loss from a contract that cannot be legally enforced. It arises through uncertainty in laws, regulations, and legal actions. From the legal's perspective, alternative investments diversify enormously across various jurisdictions and forms of incorporation. Next, hedge funds, by their nature, are private investment vehicles, which are not fully transparent or non-transparent at all. Therefore, a proper investigation of legal risks for hedge funds is more important than for any other investments. The sources of legal risk include capacity and enforceability issues, as well as the legality of financial instruments and exposure to unexpected changes in laws and regulations.
Fraud Risk presents a separate group of risks referring to the staff credibility. Again, like legal risk, this category is derived from the private nature of hedge funds as well as low transparency and document pitfalls. Often, it is included into the operational risk group as a part of people risk. However, in contrast with operational risk, which arises mostly from unpremeditated actions, fraud is always a crime of forethought. Unlike any other risks, which could hardly ever lead to losing the entire investment, fraud is a very real threat of forfeiting the whole hedge fund game. The hardest point of investigating fraud risks is that there is no bulletproof assurance to prevent it, if people want to steal, they will find a way. A few recent blowups within the industry have proven that it is real and dangerous. Therefore, considering the top priority of fraud issues, it makes sense to define them as a stand-alone category of risks.