Risk Management: Foundations for a Changing Financial World

CHAPTER 25

SOURCES OF CHANGE AND RISK FOR HEDGE FUNDS^y

Clifford S. Asness

A lot of change is on the horizon for hedge funds, particularly given institutional investors’ growing use of alternative investments. The changes will likely bring a greater focus on benchmarking, calls for increased transparency, a need for better articulation of investment strategies, rationalization of hedge fund fees, and the need for solid risk control mechanisms. The future also brings subtle shifts in hedge fund risk. And although the risk of blowups still exists, perhaps the larger future risk will relate to diminished returns.

In this presentation, I will take a big picture view of the hedge fund world, but the core of the presentation will relate to an idea that is coming up ever more frequently—hedge funds are becoming much more institutionalized. Although institutionalization can mean many different things, I will jump right in and describe it through a focus on five key issues that come up as a consequence of institutionalization: benchmarking, transparency, articulation of the investment strategy, fee rationalization, and risk control.

BENCHMARKING

For better or worse, institutionalization brings about a greater focus on benchmarking. And a myriad of ways exist to set up a benchmark depending on whether the investor wants to analyze an individual hedge fund manager or a hedge fund program. Probably one of the most basic benchmarks is a simple absolute number, which could be any number that ...