From the December 2008 issue of Investment Advisor • Subscribe!

December 1, 2008

New Risk Measures

The bad news in the global hedge fund industry has been hard to escape during this economic and market crisis as substantial investor redemptions, large losses, and outright closures owing to dismal performance dominate the headlines. To be sure, this unprecedented time of volatility and uncertainty is creating challenges many investors and managers have never seen.

Spooked by hedge funds' worst-ever returns at a time the average fund, according to Chicago-based Hedge Fund Research Inc., has lost 20% this year, pension funds and wealthy individuals alike are leaving hedge funds faster than ever before.

Between July and September, investors pulled out a record $31 billion, which helped shrink the industry 11% to $1.7 trillion. More redemptions are expected to flood in by the November deadlines to get money back by year end. HFR's Global Hedge Fund Index showed hedge funds through October 28 had lost 20.2%.

But from these difficult times, investors and funds have an opportunity to learn valuable lessons, including a closer look at risk management.

A new calculation, created by Paris-based risk management solutions provider Riskdata, may provide a better understanding of risk across markets, asset categories and even hedge funds themselves. Riskdata developed "ShockVaR" about a year ago to overcome the possibility of overestimating risk during calm periods and underestimating it in highly volatile markets. ShockVaR is much more reactive to market changes than typical VaR measures, which focus on the maximum estimated amount a security, portfolio, or index may lose at a given time horizon for a specific confidence level.

"ShockVaR is less stable than long-term VaR," explains Riskdata Chairman Ingmar Adlerberg. "It may increase sharply within days of a shock or anticipated shock and drop down to its initial value if the market volatility is back to previous levels."

Riskdata's ShockVaR calculations, for example, accurately pointed to the increased possibility of a dramatic drop in the Japanese equity markets the week of October 20... anticipating the big drop experienced on October 24.

"In the ongoing market crisis, when uncertainty rules the day, maximum insight into the relative risks of various instruments becomes a key for achieving selectivity in redemptions and investment decisions," said Adlerberg. "The goal of ShockVaR is to help investors better analyze their portfolios in the current market crisis."

Part of the Toolchest

Adlerberg says that these indicators should be used in concert with an investor's full spectrum of risk analytics to "discern and separate real from imaginary investment threats."

Quite interestingly, Riskdata, in concert with data provider Hedge Fund Research, began calculating ShockVaR for hedge fund categories, thereby giving investors another gauge by which to help determine the relative riskiness of these investments in the short term compared to historical measures.

For example, through this past October, the convertible arbitrage and market directional categories were showing the highest level of near-term risk, reflecting a view that they could experience much higher near-term losses than other categories. Conversely, macro and equity market neutral had short-term risk measures that were very close to the historical norms, indicating that risks in those categories were not unusual.

Investors who try to anticipate and understand the risks they have in their portfolios will continue to have an advantage over those who don't. Investing in markets or funds that have done well in the past with returns or performance that is hard to understand is a practice not likely to be repeated.

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