Institutional Investor's Alpha Magazine - September 2008 - (Page 59)

Strategies Risk Management Tails, You Lose By Irwin Speizer IN AN INCREASINGLY UNCERTAIN FINANCIAL WORLD, ONE THING IS CERTAIN: TAIL EVENTS CAN DEVASTATE A HEDGE FUND PORTFOLIO. G reg van Inwegen is in the catastrophe avoidance business. As chief investment risk officer at Ivy Asset Management, a $15 billion fund of hedge funds, van Inwegen patrols his firm’s portfolios with an eye toward potential financial peril. His approach is informed by a hard-earned appreciation for the unexpected: On September 11, 2001, van Inwegen was working for Deutsche Bank in one of the buildings across from the World Trade Center. Hence the rock-climbing gear he has stowed away in a credenza in his office at Ivy’s Manhattan location: harnesses, carabiners and two 60-meter ropes — enough to rappel down from his perch on the 30th ﬂoor of the Midtown high-rise. “I don’t expect to ever use it,” says van Inwegen, a recreational climber. “It sits in there gathering dust. It’s tail-risk management.” As van Inwegen recognizes, today’s financial risk managers face an uncertain world that is subject to market tail events — those statistically unlikely occurrences that can have an outsize impact on returns. Tail events are like Murphy’s Law on steroids: If anything can go wrong, it will — and in a very big and messy way. Divining where or when such events might occur, de- termining how they might affect investments and trying to defend against them are the risk manager’s ultimate test. An alarming number of hedge funds have failed at these tasks during the past year, raising questions about the application of risk management methods across the industry. Hundreds of billions of dollars in wealth have been destroyed by an especially strong and persistent series of tail events: the subprime market meltdown that began in the spring of 2007, the winter credit crunch, and this summer’s sharp and sudden fall in the prices of commoditiesrelated stocks. The punishment for failing to properly prepare for and protect against these events has been swift and merciless. Peloton Partners, a London-based hedge fund company run by a pair of Goldman, Sachs & Co. veterans, illustrates the problem. Its $1.8 billion, heavily leveraged asset-backed-securities fund went from being a star performer in 2007, with an 87 percent return, to collapse in early 2008, after the ﬁ rm bet that mortgage bonds would rebound. They didn’t. Instead, the credit crunch undermined the value of the ﬁrm’s long bond positions so badly that Peloton was unable to raise enough collateral to meet margin calls. The growing list of tail event casualties — which just SEPTEMBER 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 59

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - September 2008

Institutional Investor's Alpha Magazine - September 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Culling the Herd The Good Guys: Ending the Cycle Interview: Press Credentials Cover Story: Rethinking Chris Hohn Strategies: At the Edge of the Earth Profile: Alpha Femals Strategies: Tails, You Lose Research Center: The Top Equity Trading Firms Alpha Bytes: The Light Is On Unhedged: Commentary: Not-So-Dire Diagnosis

Institutional Investor's Alpha Magazine - September 2008

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