Institutional Investor's Alpha Magazine - September 2008 - (Page 62)

Risk Management quidity risk,” says Alexandra Investment’s Movchan. Several industry groups, research organizations and government panels have called for improvements in practices to help dampen the impact of tail events. In July, Celent, a Boston-based ﬁnancial research and consulting ﬁrm, issued an extensive report on liquidity risk, which it identiﬁed as the root cause of the latest crises. Among its recommendations: Use stress testing and modeling to more accurately measure risk exposure from complex products, then set aside enough capital to cover a liquidity crisis in those investments for a ﬁxed period of time. A “Temporary heroes are made from leverage and concentration,” says Welton Investment Corp. founder and CEO Patrick Welton. a snapshot of risk practices before the subprime meltdown. One of the most widely used risk testing methods cited by hedge funds in the survey was Value at Risk, which estimates the maximum potential loss in a portfolio at a given probability (usually set at 99 percent) over a set time period. But standard VaR tests were designed for so-called normal markets rather than turbulent ones and tend to be ineffective during tail events. Deloitte recommends that risk managers overlay additional metrics like stress and correlation tests to get a better portrait of exposure. Sixty percent of respondents who were using VaR also did stress and correlation testing, leaving the portfolios of the 40 percent who used only VaR dangerously vulnerable to tail events. The survey also found problems in valuation practices for instruments like credit default swaps. Accurate valuation data is critical to running effective stress and correlation tests. The danger of inaccurate valuation in those types of lapses is that funds can underestimate their risks. Low risk estimates can serve as a green light to portfolio managers for boosting leverage — a tactic that can dramatically magnify the effect of a tail event. That scenario played out at Dillon Read, where an overreliance on VaR was partly blamed by UBS’s own management for the inaccurate estimate of the ﬁrm’s risk exposure. “I think the biggest lesson from recent events is that the whole hedge fund industry needs to be much better at identifying, managing and pricing risk, especially li- t some hedge fund ﬁ rms, risk management is woven into the entire investment process. New York–based D.E. Shaw & Co., for one, has put in place a framework designed to keep it from being swallowed up by tail events. Guiding the effort is a risk management committee whose four members are all part of the six-person executive team that runs D.E. Shaw. The committee sets the ﬁ rm’s risk policy and parameters and meets at least every two weeks to review positions and strategies, market movements and risk proﬁ les. Portfolio managers are responsible for monitoring and measuring their own risk proﬁ les and adhering to the ﬁ rm’s risk outlines. Their compensation is based on performance, which includes the risk-adjusted returns they generate. D.E. Shaw also has a chief risk ofﬁcer, who monitors the ﬁrm’s various portfolio positions as well as its overall risk proﬁ le. Since 2006 that position has been ﬁ lled by Peter Bernard, who previously served as president of RiskMetrics. Bernard reports directly to the risk committee, putting him on equal footing with portfolio managers. Eric Wepsic, a D.E. Shaw managing director and member of the risk management committee, refers to the system as a combined bottom-up, top-down model designed to keep several sets of eyes watching the ﬁrm’s risk proﬁle. “We want to generate good returns in a sustainable and responsible way,” Wepsic says. “Avoiding catastrophic risk is a fundamental part of that.” For van Inwegen, an unexpected event two years ago provided a wake-up call that led to reforms in Ivy’s risk management methods — and to a boost in his authority. Ivy had major investments with Greenwich, Connecticut– based hedge fund Amaranth Advisors, a play that backﬁred when a trader at that ﬁrm placed a huge bullish bet on natural gas — and lost. At least three Ivy funds were invested in Amaranth, which was forced to close after dropping $6.5 billion in less than two weeks in September 2006. Spooked investors withdrew $1 billion from Ivy, prompting its management to restructure. Although Ivy’s risk managers had spotted Amaranth’s concentrated bet on energy by spring 2006 and sounded an alarm, its investment managers, who had the last word, waited too long to act. In the post-Amaranth shake-up, Ivy elevated risk management to a position equal to that of the firm’s investment managers. Van Inwegen now chairs a risk Photo by Darcy Padilla for Alpha 62 • 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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