Hedge Funds: Still Risky Business

So, although the overall hedge fund category is far more diversified, and counterparties were able to move swiftly to stem any lasting damage from Amaranth, one continued fundamental of hedge fund investing was proven by this scenario: A single set of too-risky investments can undo everything that improved diversification and controls were supposed to prevent. That raises a host of questions, which Standard&Poor’s answers here.

What are the primary risks in hedge fund investing today? They fall into two main categories: investment risk and operational risk. Investment risk covers the way in which the fund invests: the strategy (or strategies) used, the amounts allocated to each strategy, the instruments in which the fund trades, and the fund’s investment philosophy. It also covers liquidity because hedge fund managers need to match the portfolio’s liquidity needs with that of the many illiquid instruments in which they invest. Operational risk incorporates the investment structures as well as the processes and controls used by hedge fund investment managers to implement their strategies. It covers valuation, transaction recording and settlement, corporate governance, and, of course, fraud.

Which risks were expressed with the recent Amaranth collapse? The collapse appears to be an example of risk-taking that ended unfavorably. The fund had highly trained, experienced individuals on its risk-management team as well as systems to monitor the relatively large energy exposures taken. However, Brian Hunter, the 32-year-old head trader for the fund, was permitted to use a high-risk strategy similar to one that has been successful in the past. Unfortunately for Amaranth, this time it was not.

Will Amaranth’s meltdown squelch investing in hedge funds? At this point, that scenario is unlikely. Investment assets were flowing into hedge funds at a remarkable clip before Amaranth’s big loss and are still doing so. The strategies many hedge funds employ to achieve lower volatility and higher risk-adjusted returns over time continue to attract assets, even though few hedge funds today still reap the very high returns of the 1990s. Indeed, a hedge fund with such returns, especially if coming from only one sector, should be a red flag to investors. Due diligence by hedge fund investors cannot end with the placement of funds but must continue throughout the life of the investment.

Will changes emerge from prime brokers and hedge fund managers to mitigate the potential for such losses in the future? For hedge fund managers, the dreaded”D”word–disclosure–is going to raise its head, most likely at the insistence of hedge fund investors. Traditionally, presentations by hedge fund managers provide details about the fund’s investment philosophy and style, but offering documents are far sketchier and give traders unusually broad latitude for implementation. From what we have been hearing, investors will most likely demand far more detail about investment strategies and guidelines in the offering documents and will want tighter terms and conditions around implementation.

Whether prime brokers will require more collateral from hedge fund managers is still unknown. Interestingly, one reason the LTCM failure was so spectacular was that its prime broker required far lower levels of collateral than, in hindsight, would have been prudent. So the enormous leveraging in which the fund’s traders engaged was backed, comparatively, by not much more than the traders’ reputations.

We expect to see hedge fund managers and prime brokers be much more cautious about their counterparty relationships. In a potential meltdown situation, unresponsive counterparties can exacerbate liquidity difficulties to the point where losses wind up being greater than they needed to be.

Are formal regulations likely to be strengthened? Securities regulators have long focused their attention on hedge funds. Questions surrounding whether to increase oversight will continue to be under the microscope for some time.