Institutional Investor's Alpha Magazine - September 2008 - (Page 63)

committee that reviews all investments and has greater authority to demand changes in investment positions if he spots problems. Ivy also beefed up the system it uses to proﬁ le the individual fund managers with whom it invests, rating them not just on performance and operational standards but also on leverage, liquidity and the likelihood that they might get caught by a drawdown similar to what happened at Amaranth. The ﬁrm also instituted a metric to ensure that no individual hedge fund gains too large a position within a portfolio, using green, yellow and red ﬂags to rate funds. Under the yellow caution ﬂag, an Ivy portfolio manager has to justify the level of investment held in a particular hedge fund. Under a red ﬂag the position must be reduced immediately — no questions asked. “In general, the process will maintain a discipline, so that the overall portfolio is not going to get hit by that kind of tail event,” says van Inwegen, who has a Ph.D. in ﬁnance from the Wharton School of the University of Pennsylvania. “That is what you are looking to avoid.” For Welton, the Carmel, California–based manager, the two key investment considerations in risk analysis are leverage and concentration. Avoiding potential traps in those two areas, he says, can shield a fund from many of the types of problems that surfaced over the past year. “Temporary heroes are made from leverage and concentration,” says Welton, who got his start in finance in the late 1980s trading futures and options for Commodities Corp., the Princeton, New Jersey, company that launched the careers of many renowned traders, including Paul Tudor Jones II and Bruce Kovner. The firm Welton founded in 1989 maintains four levels of risk monitoring and review. Portfolio managers and traders are required to report risk considerations in all investment decisions. A portfolio review manager examines those decisions and reports on risk matters to the ﬁrm’s senior management. A separate compliance and risk manager independently inspects positions and also reports ﬁndings directly to senior management. The ﬁnal stop is Welton himself, who evaluates risk proﬁ les and reports and, together with his top managers, sets risk parameters. But even ﬁrms with risk controls and multiple levels of review can’t totally immunize themselves. “You can’t eliminate all the risk,” Welton says. “So the discussion becomes, Are the risks understood? Is there compensation for their assumption? and, Can we absorb them so we don’t have what we might call catastrophic risk?” For risk managers, understanding the issues and knowing what questions to ask is only half the battle. The investment world is populated by characters with notoriously oversize egos and a voracious appetite for proﬁt. An impressionable risk manager with an academic rather than ﬁ nancial background parachuted into that environment can easily be overwhelmed. Indeed, one of the criticisms raised in the recent round of losses is that risk managers didn’t stand up to traders. Satyajit Das, a former investment banker who now works as a risk consultant in Australia and is the author of a book on derivatives and risk called Traders, Guns & Money, says the personality and character of the risk manager plays a central role in the effectiveness of a fund’s risk management. Only strong-willed types with inquisitive minds will do. “What’s important now is getting the right type of risk manager,” Das says. “He has to be the devil incarnate: internally skeptical, externally suspicious, not someone who is a patsy and rolls over and wants his stomach tickled. Today the patsies are winning.” MIT ﬁ nance professor Lo agrees that risk managers need to be strong enough to stare down traders within their own ﬁrms. He also subscribes to the principle that risk managers must rank high enough to be able to challenge or overrule portfolio managers. At Lo’s hedge fund ﬁrm, AlphaSimplex, chief risk ofﬁcer Arnout Eikeboom not only reports directly to the CEO but also has the authority to readjust investments by executing trades. Eikeboom has a signiﬁcant incentive for taking a hard line on risk: His employment contract stipulates that he must ensure that investments stay within the ﬁrm’s established risk guidelines. If risk levels get out of whack, he can be terminated immediately. “He has unilateral authority to shut down any strategy or to tell traders to unwind strategies,” Lo says. “He doesn’t have to ask me if a trade should be taken off. A lot of portfolio managers don’t like this, but that is the point.” Lo argues that still more needs to be done to improve “We want to generate good returns in a sustainable and responsible way Avoiding . catastrophic risk is a fundamental part of that.” — ERIC WEPSIC, MANAGING DIRECTOR, D.E. SHAW & CO. hedge fund risk management and that the missing link is some form of government or quasigovernmental oversight. The paucity of reporting requirements for hedge funds makes it difﬁcult to understand and learn from fund failures, he says. Without that solid data, risk managers remain hard-pressed to make truly accurate projections of risk and to recommend appropriate hedges. Ultimately, the challenge facing hedge funds is how to structure investment strategies that can produce betterthan-average proﬁts without endangering the ﬁrm’s capital in a tail event. In many cases, these risk strategies are, like van Inwegen’s climbing ropes, the only way out in an emergency. As van Inwegen says, “I always want to have exit options.” SEPTEMBER 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 63

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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