Risk Management: Foundations for a Changing Financial World

CHAPTER 26

RISK MANAGEMENT IN A FUND OF FUNDS^z

S. Luke Ellis

For the fund-of-funds manager, managing risk in a portfolio of hedge funds requires, first, recognizing that the return distribution of hedge funds is not normal and, second, taking into account the market crisis events that should happen rarely but that, in fact, occur every two to three years. Fortunately, value at risk methodology can be adapted for measuring the normal risk in the fund portfolio and, with some modification, can be applied to estimate how much the portfolio might lose in a crisis. In addition, modeling crises as coherent events allows one to estimate the likely amount of loss requiring a hedge, even though the particular nature of a future crisis may be unknown.

The most important point about managing risk in a fund of funds is to recognize that it is completely different from managing risk in an underlying portfolio. The manager of an individual portfolio can easily adjust risk. A fund-of-funds manager, however, allocates money out to other managers. Although a fund-of-funds manager can manage risk at the overall portfolio level, the fundamental piece of risk management that occurs at the security level is outside the direct control of a fund-of-funds manager because it is, in essence, outsourced. Consequently, a huge part of risk management for the fund-of-funds manager is about picking who gets the money. Thus, managing risk at the security level is about monitoring.

Given the limitations on security-level ...