Risk Management: Foundations for a Changing Financial World

CHAPTER 23

RISK MANAGEMENT FOR HEDGE FUNDS: INTRODUCTION AND OVERVIEW^w

Andrew W. Lo

Although risk management has been a well-plowed field in financial modeling for more than two decades, traditional risk management tools such as mean-variance analysis, beta, and Value-at-Risk do not capture many of the risk exposures of hedge-fund investments. In this article, I review several unique aspects of risk management for hedge funds—survivorship bias, dynamic risk analytics, liquidity, and nonlinearities—and provide examples that illustrate their potential importance to hedge-fund managers and investors. I propose a research agenda for developing a new set of risk analytics specifically designed for hedge-fund investments, with the ultimate goal of creating risk transparency without compromising the proprietary nature of hedge-fund investment strategies.

Despite ongoing concerns regarding the lack of transparency and potential instabilities of hedge-fund investment companies, the hedge-fund industry continues to grow at a rapid pace. Lured by the prospect of double- and triple-digit returns and an unprecedented bull market, investors have committed nearly $500 billion in assets to alternative investments. Even major institutional investors such as the trend-setting California Public Employees Retirement System are starting to take an interest in hedge funds.¹

However, many institutional investors are not yet convinced that “alternative investments” is a distinct asset class, i.e., a ...