Hedge Funds of Funds: A Guide for Investors

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The Hedge Funds of Funds Risk, Monitoring and Portfolio Management Processes

7.1 OVERVIEW – RISK AND HEDGE FUNDS

The sources of risk vary widely from hedge fund to hedge fund. In some cases, the risk a hedge fund takes can be broadly represented in the volatility of its track record, e.g. in Equity Long/Short funds that trade stocks with larger equity caps. However, in many hedge funds, measuring the risk is not so straight forward. For example, a lot of risk may lie with the liquidity of the portfolio – less liquid instruments do not trade in a nice smooth way but they generally move in jumps when traded. As a result, should a hedge fund hold instruments of poor liquidity, this may provide a risk that is not yet reflected in the track record.

As well as hidden risk due to liquidity of a portfolio, there are some other risks that do not always reflect themselves in track record. Hedge funds may hold nonlinear instruments such as options and other derivatives which behave in ways that have less obvious impact on track records, e.g. if a hedge fund were to sell put options on the equity market this would give a steady uncorrelated return stream as long as the market didn't fall but would cause considerable loss if it did. Similarly, hedge funds that own sub-investment grade bonds will enjoy a great steady static return from the coupon the bond pays but should the issuer default, they will lose the coupon and incur losses from the decrease in the price of the bond.

Arbitrage strategies ...