Key Concepts

1.. Risks faced by hedge funds occur at die investment level and portfolio level. At the investment level, investments are subject to structural risks from an individual hedge fund's operations. In addition, a hedge fund is exposed to strategy risks like:

• Market risk from adverse price swings.

• Credit risk from non-performing counterparties.

• Funding liquidity risk from the inability to meet interim cash flows.

• Trading liquidity risk from potential market impact of large trades.

2. Investment styles contain several different hedge fund strategies. Each hedge fund strategy has its unique exposure to primary risk factors, such as market risk, credit risk, and liquidity risk. Understanding primary risks is central to understanding strategy risk, the effect of leverage, transparency issues, and risk management issues.

3. Leverage is not a primary risk factor per se, but magnifies the distribution of returns and, hence, risk. It may also amplify certain primary risk factors, such as market and liquidity risk. It can originate from either the hedge fund using credit to fund its positions, known as balance sheet leverage, or from the risldness inherent in the hedge fund's investments, known as instrument leverage.

4. The level and type of transparency and disclosure depend on the fund's investment strategy. Maximum transparency may not always be useful or may compromise investor returns.

5. Proactive risk management entails asset allocation (which focuses on quantitative analysis of strategy risks) and due diligence (which focuses on qualitative analysis of structural risks).

6. At the investment level, on-going risk monitoring and management focuses on detecting and anticipating style drift among managers, particularly for funds with out-of-favor strategies or particularly poor returns. At the portfolio level, risk monitoring entails assessing trends in primary risk factors and asset flows into and out of different strategies.

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