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

Chapter 7

Risk Management for Hedge Fund Investors

Many investors are eager to make a hedge fund investment and assets under management at hedge funds continue to grow. The opportunity to improve returns and reduce risk is enticing. However, there are many issues relating to risk and risk management that an investor needs to be aware of before committing to such an investment. Mastery of these issues or engaging a skilled advisor or fund of funds manager greatly increases the odds of long-term success.

A partial allocation to hedge funds as an asset class can improve the risk-return profile of most investment portfolios. Specifically, specially constructed hedge fund exposures can complement a traditional investment portfolio. For example, an investor wanting to reduce his directional exposure to changes in interest rates without reducing income may lower the duration of his fixed income allocation but add a specific lower-volatility hedge fund or a fund of hedge funds heavily or exclusively weighted towards non-directional arbitrage strategies as a partial replacement for a portion of his fixed income exposure. Similarly, a more sophisticated investor seeking greater short-term equity exposure may choose to keep overall allocations of equity and fixed income risk factors fairly stable, but replace some his directional equity exposure with long/short equity hedge fund exposure. This would serve as a partial equity beta hedge to protect on the downside. An investor seeking primarily ...