There are a couple of trends that have actually been going on for quite a long time.  First of all, in terms of risk measurement, and I’ll probably elaborate on that later, but risk measurement is only a part of risk management, but it’s really the foundation of risk management because until you can measure your risks you really can’t act upon them.  And over the past decade there’s been a lot of, I would say, advances in terms of risk measurement.  What types of risk should be measured, how they should be measured, and how they should be reported and communicated to investors?  So, that’s really been an ongoing trend, and since institutional investors began investing in hedge funds about a decade ago, many hedge funds have had to improve their risk analysis and reporting.

So, that’s been sort of an ongoing trend which I think has been a good thing.  Secondly, you asked me about tools.  Well, certainly derivatives, for example, as risk mitigating or risk management tools have been around for quite a long time, but there are some instruments like credit default swaps that are newer.  So, the tools that are available to investors and hedge fund managers have been increasingly improving as well.

Well, for example, liquidity risk is certainly very, very difficult to model because we can look at historical patents of liquidity for any asset class and say, okay, well, this bond has traded with this much liquidity over the past five years, but as we all know, unlike in many equity markets, the bond market can really seize up during times of stress, so that’s very hard to evaluate.  There are certain instruments like listed equities and futures contracts that are going to be reasonably liquid even in stressful times, but anything outside of those types of asset classes are going to possibly face significant lack of liquidity under stress.

I would actually say false.  Asset allocation is extremely important in terms of understanding the risks in your portfolio.  I think many asset allocators or managers focus too much on the return components of their investments, and only after they have assembled their portfolio do they stay back and look at, “Okay, well, what does the resulting risk look like?”  And I think the assessment of risk has to be really baked in to the initial investment evaluation process, so if you think this particular investment is attractive because it has this time of return profile, you also have to think simultaneously about the risk that you’re taking to get that return. 

Now, that may sound fairly obvious.  Any textbook on investments will tell you that you have to consider risk as part of return, but I think, historically, particularly during bull markets, many managers have forgotten that basic lesson.

I think any type of instrument that really depends on market makers providing liquidity.  I mean, the bond market, for example; the bank loan market, for example.

Credit markets.

Credit markets.  And although many derivative contracts now being transferred to exchange clearing, you still have over the counter derivative contracts that are bilateral contracts between you and the bank, so clearly –

Can you share some of your views with us on risk budgeting and allocation?

Sure.

What’s the right way to determine position sizes?

Again, academic theory suggests that you should consider risk as part of your position sizing and portfolio construction process, however my experiences being that many managers really don’t apply risk budgeting in a rigorous way.  So, to give you a very simple example, an equity manager might say, well, I’m going to invest in Stock A and Stock B, they look equally attractive to me from a return point of view, however one is a very large cap value stock and the other one is a, let’s say, a small cap growth stock then allocating equal dollar amounts to these two stocks will result in very different levels of risk. 

You might find, actually, that the small cap stock if four or five times the risk as the large cap value stock.  So, how do you then size that position?  Well, you know – and many managers still don’t really think about that in a systematic and rigorous way.

Although do they think about it in bonds?  You know, we have duration and other measures of risk in the fixed income markets.  It certainly lends itself to that sort of framework.

Sure.  It should, but I still find that many credit managers, for example, still size positions and allocate capital based on, shall we say, more simple measures.

Sure, and in a high yield that’s probably a little more fair given how those instruments behave, and certainly there’s another example of where the liquidity risk management is absolutely key because things were liquid in that market until they’re not.

Okay.

There’s certainly been tremendous amount of interest in tail risk strategies because clearly a lot of investors want to avoid the mistakes or the losses that they incurred during the financial crisis.  So, having said that, most tail risk strategies involve buying options, buying deep out of the money put options, for example, on the equity markets, and raises a couple of different issues.  One is: is this something that you should be doing?  Is this the type of extreme risk that you should paying premium to hedge?  And there are certainly many institutional investors, for example pension funds, who feel that they can’t really afford to lose more than a given amount of loss. 

Very high premiums.  And if you are in a competitive business like the hedge fund business or the fund-of-funds business, can you afford to show lower returns than your competition to mitigate that risk.

It’s an important trade off.

In terms of risk reporting, is what hedge funds are currently reporting adequate, is position level transparency necessary, or are factor exposures adequate and more important in any case for the typical investor who’s receiving these reports?

I think that risk reporting on the part of hedge funds has improved dramatically, partly because of investor demands and pressure.  The challenge is that there’s no uniformity, first of all, in the industry.  It varies from strategy to strategy and fund by fund, and there’s not common framework or set of rules that govern what a hedge fund should report.  So, that’s sort of the first challenge.  The second challenge is that there are certainly many managers who are willing to disclose complete transparency, position level transparency, because they do not feel that giving that away to investors, at least, really will jeopardize their strategy. 

However, once you are given complete position level transparency, what do you do with it?  Because many institutions who ask for that really don’t have the systems, the software, and the analytical and interpreter roles and skills to really know what to do with that information because just knowing that you have a $100 position in a given stock really is not going to help you manage the overall risk that you’re running.  It’s only when you can transform that granular position level data into things like common factor risks that then you can start to think about risk management.

Right, so it’s a great question, how many investors are actually sophisticated enough to model these exposures, especially position level, into factor exposures in an actionable way.

Exactly, that’s right.

Ken, thank you again for joining us today.

You're welcome.

I'm Wendy Coleman for the CAIA Association.