Institutional Investor's Alpha Magazine - September 2008 - (Page 60)

Risk Management this month claimed mortgage giants Fannie Mae and Freddie Mac and 158-year-old investment bank Lehman Brothers — has sent hedge fund managers scurrying for protection. They are hiring more qualiﬁed risk professionals at higher pay (see box) and giving them increased authority over investment decisions, including the power to order more hedging or even to unwind positions deemed too speculative. Hedge funds are also investing more in software and services. New York–based RiskMetrics Group, a leading ﬁ nancial risk management software and services company, witnessed a 31 percent jump in revenue during the ﬁ rst six months of 2008 over the same period in 2007. Damian Handzy, chairman and CEO of Investor Analytics, which also supplies such systems and services, says demand for his company’s products has been soaring. “I have been in this industry for ten years, and I have never seen so many fund managers interested in risk,” he adds. The solutions offered by ﬁ rms like RiskMetrics and Investor Analytics revolve around more-extensive testing and analysis of investments, using techniques like stress testing and correlation modeling to try to estimate how different scenarios might affect portfolios. Comprehensive historical databases offered by these companies provide information for more-robust risk tests. Still, most of the changes in risk management during the past year have been more incremental than breakthrough. Many hedge funds, including some run by large and sophisticated banks, were already beeﬁ ng up risk management efforts more than a year ago yet got swamped by the ﬂood of tail events. As van Inwegen says, “Over the past year these tail events just came up and hit you.” Hubris nurtures and sustains tail events and undercuts risk management, notes Patrick Welton, founder and CEO of Welton Investment Corp. of Carmel, California, a $500 million hedge fund specializing in managed futures and global macro strategies. “Human beings have a behavioral problem: They believe they control more things than they do,” he explains. “But it is impossible to understand all the changes that can take place. There will always be a new case in the future that we didn’t anticipate in the past. If you don’t have humility and include that in your risk assessment, you won’t be prepared.” In August, New York–based Ospraie Management’s $2.8 billion ﬂagship Ospraie Fund fell 26.7 percent, battered by the sell-off in the energy, mining and naturalresources sectors. The fall in these stocks was so swift and so steep that it caught Ospraie off guard, leaving the fund vulnerable to such heavy redemptions that founder Dwight Anderson had little choice but to announce that he would be shutting it down. Ospraie joined a long line of hedge funds that have fallen during the past 16 months, starting with the spectacular collapse of Dillon Read Capital Management, shuttered in May 2007 by parent UBS following the fallout from the Swiss bank’s $37 billion in subprime-related losses. That spring two Bear Stearns Cos. credit funds lost $1.6 billion, hastening that venerable ﬁrm’s demise; JPMorgan Chase & Co. bought Bear this May for $10 a share, a fraction of the $150 price its stock commanded a year earlier. May also saw New York–based Drake Management shut down its $2.5 billion Global Opportunities fund after it got crushed by the credit crunch. Lo says the fact that widespread losses piled up with armies of highly trained risk managers on the watch “points to one ineluctable conclusion: Something is broken.” The calls for change from investors, fund managers, consultants and academics revolve around two distinct issues: analysis and management. Put another way, the challenge is ﬁrst to understand how much risk a particular investment might face, particularly during a tail event, and then to do something about it to protect the integrity of a ﬁrm’s ﬁnances. Of course, one of the biggest problems is that risk managers often lack sufﬁcient authority to unilaterally order corrective action when they see problems; too many are outranked by portfolio managers who can simply ignore their counsel. Yet even if risk managers were given more authority, it is far from certain that they could have protected their firms from the recent spate of events. Predicting the future during turbulent markets is still a guessing game. “Nobody has a crystal ball,” muses Oleg Movchan, director of risk management at Alexandra Investment Management, a New York–based hedge fund ﬁrm with $1 billion in assets. “Nobody can forecast what is going to happen. What you can do is prepare the ﬁrm for a situation when a tail event does happen.” “Until we start to model herd mentality, we are never going to get a good enough handle on tail risk.” — ANDREW LO, FINANCE PROFESSOR, MIT SLOAN SCHOOL Magnifying the problem is the herd mentality of most asset managers. The phenomenon is the opposite of what has come to be known as the wisdom of crowds. Financial tail events are all about the lunacy of herds. “Until we start to model herd mentality, we are never going to get a good enough handle on tail risk,” says Andrew Lo, a professor of ﬁnance at the MIT Sloan School of Management, as well as chairman and chief scientiﬁc ofﬁcer of the $600 million Cambridge, Massachusetts– based hedge fund ﬁrm AlphaSimplex Group. “When you have certain types of ﬁnancial market dislocations, all hell breaks loose at once. This is the source of tail events.” 60 • INSTITUTIONAL INVESTOR’S ALPHA • SEPTEMBER 2008

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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