Effective risk management is not proprietary: The disclosure paradox

It has long been accepted that risk management is a core competency for generating absolute returns within a hedge fund strategy. Prior to the market downturn, hedge fund managers were able to diffuse investor requests for greater transparency in risk-management practices. However, investors, directors and regulators have been startled by the scope and magnitude of losses resulting from the market downturn and credit crisis, as well as recent breaches of fiduciary trust.

Proprietary risk management processes, once considered a competitive advantage, are now viewed as potential sources of undue risk. As a result, investors, regulators and directors are demanding formal and comprehensive approaches to governance and risk management that are open to independent third-party review and evaluation.

Hence the disclosure paradox – hedge fund managers who adopt comprehensive, formal and transparent governance and risk-management practices will more likely be able to regain investor loyalty and trust. In other words, the more openness surrounding fundamental risk and governance strategies, the more leeway there will be in terms of protecting genuinely proprietary and, therefore, differentiating competitive strategies and practices.

The rise of governance and risk management 

Hedge fund investors are expecting more sophisticated oversight functions designed to manage risks and surprises related to their investment dollars. Establishing and maintaining proper oversight verified by independent third-party evaluation is becoming a cornerstone of investor relationships. Heightened investor expectations include:

>> Greater rigour in credit and liquidity risk – Investors increasingly want assurances that hedge fund managers are able to identify, document and establish effective risk management practices related to their exposure to liquidity and counterparty credit risk.

>> Adherence to investment discipline – Going forward, investors expect that hedge fund managers will maintain investment discipline and that any changes to investment mandates will be formally approved, documented and communicated to investors.

>> Greater transparency and reliability of valuations – Volatility and illiquidity of financial assets held in hedge funds often coincide with limited independent sources of pricing data. Investors will be wary of values and performance returns without a robust and well-controlled valuation and pricing governance framework.

>> Stronger governance – Investors want to know that hedge fund managers have fundamental internal control structures in place to prevent deviations from practices such as those just described. At the very least, this includes maintaining adequate separation of duties as well as supervising and monitoring controls.

 

 

How to respond 

Hedge fund managers will find that the right investment in governance and risk management practices will serve to increase investor confidence and enhance investment and operational effectiveness. Firms are being asked to identify risks associated with their business activities clearly, outline the firm’s risk management capabilities and ensure that the firm is being compensated for the risk in which it engages. Investors will expect firms to demonstrate that they have a risk framework that has adequate governance, risk assessment, monitoring and planning programmes for the firms’ business activities.

Three lines of defence 

An emerging framework for risk governance establishes three lines of defence. The hedge fund managers and their business functions manage risk every day and know best what risks are acceptable and, therefore, bear the primary responsibility for these risks. The second line of defence usually consists of an independent, yet fully integrated, risk management and compliance function. The third line of defence provides independent testing and validation. Critical to the overall effectiveness of the three lines of defence is a senior management team and board of directors that provides a strong tone at the top and communicates that a culture of governance and risk management is of the highest priority.

Risk assessment 

Hedge fund managers should conduct periodic enterprise-wide risk assessments of their operations and major activities and augment these assessments with analyses of the higher risk areas. Targeted assessments include:

  • Conflicts of interest analysis;
  • An entitlement review;
  • Scenario analysis and stress testing;
  • Portfolio risk-exposure classification; and
  • Counter-party exposure.

Risk monitoring

Firms should then institute a monitoring programme to identify the changes that may alter the hedge fund manager’s investment profile, risk appetite, compensation structure or risk management capabilities. Successful monitoring programmes typically include one or more of the following elements:

  • Portfolio monitoring;
  • Risk limits and thresholds;
  • Causal factor analysis; and
  • Service provider oversight and counter-party risk monitoring.

Risk planning  

The third part of a company’s risk framework involves planning for a range of contingencies in areas such as capital adequacy or liquidity. Risk planning maps out the steps a firm would take if a given scenario or event should occur.

The third part of a company’s risk framework involves planning for a range of contingencies in areas such as capital adequacy or liquidity. Risk planning maps out the steps a firm would take if a given scenario or event should occur.

Conclusion 

By developing and implementing the type of governance and risk management framework described, firms can clearly identify their risks, implement appropriate risk management capabilities and verify that they are being compensated for their risk taking. This will address third-party expectations surrounding risk management, disclosure and governance while at the same time helping hedge funds achieve operational efficiency and greater profitability.

Consequently – though somewhat paradoxically – sharing more about risk and governance will instill more confidence in key stakeholders and enable hedge fund managers to share even less relating to their own specific, value-adding and generally proprietary investment strategies.

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