Hedge Fund Analysis: An In-Depth Guide to Evaluating Return Potential and Assessing Risks

Chapter 10

Risk Due Diligence

“Risk comes from not knowing what you're doing.”

Warren Buffett

“Even a correct decision is wrong when it was taken too late.”

Lee Iacocca

“In these matters the only certainty is that nothing is certain.”

Plinius the Elder

Risk resides everywhere. There are dozens of risks inherent in every hedge fund…from a simple long/short equity strategy to a complex globally diversified derivatives strategy. Following the advice of Plinius the Elder would lead one to always question the presence and potential impact of risk within an investment company and its underlying hedge funds.

Before we can go into any discussion of risk, it might be a good idea to define it. Traditionally, risk has been defined as a simple statistical measure of volatility. After all, when we refer to a risk/return graph, the “risk” portion of the graph is typically depicted as annualized standard deviation. In Chapter 6, “Quantitative Analysis,” we learned that hedge funds can be measured using dozens of risk-related statistics (drawdown, downside deviation, semivariance, etc.), and we have also covered numerous other operational and investment risks in other chapters in this book. The implication is that risk is multifaceted; therefore, we must evaluate it from a variety of different perspectives.

When I was outlining this chapter for the book, I wanted to come up with a new and innovative ...