Hedge Funds Need to Play it Safe

How much risk does your hedge fund take? In investing, some risk is acceptable–after all, risk and reward are two sides of the same coin. But investment risk isn’t the only risk you have to deal with–and not all risks are an acceptable part of doing business.

Like vendor risk, a.k.a. third-party risk.

Hedge fund vendor risk management is critical to your hedge fund’s success. The problem is that many hedge funds lag behind the curve. Here’s a look at a few common risk practices in hedge funds and how you can adjust your risk approach.

Where Hedge Fund Vendor Risk Management Falls Short

As a whole, hedge funds are small operations with only a few employees, but they’re also incredibly complex. Many hedge funds now rely on complex, illiquid assets to deliver returns, which means taking on even greater risk than ever.

Worse, hedge funds have to take on more technological risk to manage these investments. The global nature of finance now means that hedge funds are dependent on technological solutions to manage investments–and most of those solutions come from outside providers.

Granted, hedge funds are not unique in taking on more vendor risk than ever before. What’s notable is the hedge fund approach to risk: risk is part of doing business (and a necessary one, at that). This leads many hedge funds to disregard risk that they shouldn’t accept, namely vendor-related risks.

In addition, hedge funds are still closely associated with their manager for all the unique features of individual funds. To understand a hedge fund is to understand the manager in charge–their background, strengths, weaknesses, and investment preferences. This means that managers still have an outsized sway in operating the entire fund. If the manager doesn’t understand risk management (beyond a financial context), the fund will be weak and unlikely to focus time or effort.

We think it’s time for a different approach.

An Operations-Based Approach to Risk Management

Many managers fall victim to the same belief that vendor risk management isn’t their concern. Here’s the problem: your vendors are inextricably linked to how you do business.

In other words, vendor risk management directly impacts risk management in other parts of your operations.

Here are a few ways that hedge fund managers currently apply risk practices–and how you can flip those practices on their heads to create a sustainable, understandable approach to third-party risk management.

Leverage

Leverage is one of the most central concepts in hedge funds, a foundational practice in how hedge funds do business. In finance, leverage is a strategy using borrowed money to invest and grow returns.

Hedge funds can use several forms of leverage and are only really limited by their mandate. Some common strategies include:

  • Credit lines

  • Buying on margin

  • Derivative trading

For a hedge fund, there are two types of leverage: explicit leverage (which shows up on the fund’s balance sheet and includes things like margins and short selling) and off-balance-sheet leverage (where part or all of the notional value is off the balance sheet, including things like derivatives, futures, and forwards). According to a survey by The Hedge Fund Journal, 60% of respondents monitor balance sheet leverage, and 50% of respondents monitor off-balance-sheet leverage. Both sides track leverage for position and portfolio risk.

How to Mitigate It

So, what does leverage have to do with third-party risk? It’s pretty simple, actually: the technology you use for your trades.

Remember, leverage is an essential part of your investing strategy. But to execute it (and track leverage on and off your balance sheets), you need the proper analysis tools. And if you’re like most hedge funds, you rely on a third-party tool to do it.

Because of that, an excellent way to start thinking about third-party risk and leverage is to correlate business objectives with risk management activities. In other words, identify the risk that vendors introduce with access to your balance sheets and strategies and craft risk management objectives that align with your goal as a hedge fund. Basically, identify what you’re trying to achieve, then identify ways that also manage risk.

Value at Risk

Value at risk, or VaR, is a statistical technique used to measure the amount of potential loss within a position, portfolio, or firm over a specific time period. In other words, it assesses the potential loss for a given financial entity and the probability that said loss would occur. It can be computed using historical, variance-covariance, or Monte Carlo methods.

According to The Hedge Fund Journal, this is another common technique among hedge fund managers. 55% of respondents use VaR to analyze individual position risk, while 69% of respondents use it to analyze portfolio risk.

Because of the complexity of VaR models, the use of VaR is generally correlated with firm size. Larger firms are more likely to use VaR, and when small firms use it, VaR is done either by the prime broker or a third-party analytic provider. However, large firms still rely on third-party modeling software to handle their statistics, even if the practice is more widespread than just the prime broker.

How to Mitigate It

In the case of VaR, third-party risk is fairly easy to identify: the software you use to complete VaR analysis, whether you outsource the number-crunching to a third-party partner or complete it in-house using third-party software. The software has to run data on your investments, which means that it also gives insights into your strategies.

A good way to get a handle on this is a tactic called value-based risk management. Value-based risk management begins by recognizing that it isn’t possible to protect all of your data equally–there isn’t enough manpower or hours in the day. More importantly, not all of your data needs the same level of defensiveness.

Under a value-based risk management approach, you prioritize protecting your crown jewels–the data that’s most valuable to your firm. In doing so, you align risk management practices with business success, in that protecting your most valuable data makes it possible to leverage that data.

Your Expert Partner in Hedge Fund Risk Management

As you can see, hedge fund vendor risk management isn’t just a hypothetical good idea. It’s part of doing business successfully. And it all begins with the right tools.

That’s where we come in, with powerful risk management solutions tailored for the financial industry. Our job is simple: to take the headache out of risk management so that you can focus on what you do best.

Sound good? Then get in touch today to learn more about how we can help strengthen your hedge fund.

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