Managing Hedge Fund Risk and Financing: Adapting to a New Era

Business risk Management Strategies

The previous section looked at the investment risks that hedge funds face. These arise from the securities in its portfolio. Other risks faced by hedge funds arise in large part from the hedge-fund business model which, by its very nature, is fragile because the vast majority of its operations are outsourced and because of its dependency on third parties for funding (see Figure 3.2).

Figure 3.2 Sources of funding and operational risk in hedge funds

Operational Risk

An operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, data, or from external events which preclude a firm from executing its business model as intended. The hedge fund industry is neither static nor homogenous. Operational pressures are constantly changing as the industry reaches upstream to large institutional investors such as pension funds, trades with numerous mammoth financial institutions, and responds to divergent and changing regulatory environments. As such, operational risk is a multifaceted concept and challenging to manage, both for hedge fund managers and their investors.

Capco, a global business and technology consulting firm and an early specialist in back office and risk management services to the financial industry, reports that operational risk is the sole cause of almost half of all hedge-fund failures ...