Hedge Fund Risks

AIM: Identify and discuss the types of risk faced by a fund of hedge funds.

Hedge funds face structural risks that stem from a hedge fund's operations similar to operational risk. These risks include the potential for deterioration in a firm's reputation, poor information reporting systems, and inadequate management oversight. They are important because they can affect a hedge fund's security selection or can trigger a wave of redemptions that impose costs on investors.

Strategy risks come in different forms and derive from the hedge fund's investment strategy, the risk factors that are peculiar to that strategy, and the execution of the strategy. One type of strategy risk is market risk, which is the risk of adverse price swings for different asset classes. Some investment strategies (such as relative value strategies that take long-short positions in similar assets) are largely immune from market risk, while other strategies (such as directional equity strategies) are more vulnerable to market risk.

Another type of strategy risk, credit risk, arises from the possibility that a borrower or counterparty will not perform its contractual obligations. It is more pronounced for distressed security strategies but less severe for relative value strategies that use futures contracts, the performance of which is secured by a clearinghouse.

Funds vulnerable to trading liquidity risk are exposed to the possibility of large price impacts from executing large trades, perhaps because of forced liquidation. To manage this risk, a hedge funds strategy should match its redemption policy. A fund with illiquid positions should not permit frequent redemptions on short notice.

Funds with funding liquidity risk may not be able to meet interim cash flow obligations from margin calls or marking-to-market that could arise before their strategies become profitable. Both trading liquidity risk and funding liquidity risk materialized in the Metallgesellschaft and LTCM cases, demonstrating that they are often positively correlated, particularly during an economic crisis when liquidity dries up and margin calls ensue.

In contrast, market risk and liquidity risk might be negatively correlated. For example, relative value strategies using over-the-counter contracts are largely insulated from market risk but prone to liquidity risk. Likewise, directional strategies using exchange-traded instruments enjoy liquidity but are vulnerable to market trends.

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