Asia funds of hedge funds ramp up risk management

Leading alternative asset investors are placing a higher focus on the ability of funds of hedge funds in Asia as well as hedge fund managers to respond quickly to volatile markets following the collapse of Lehman Brothers in 2008.

"Since the crisis we have seen a change in the fund of hedge funds and hedge fund industry – you need people with some trading background to be able to talk about risks as you need to react quickly," says Miodrag Janjusevic, chief risk officer at fund of hedge funds, Sail Advisors, in Hong Kong, "The crisis has showed you can't delegate the responsibility of risk management to someone else and hope you won't get hurt."

Managers must clearly demonstrate they are not reliant on the structuring capabilities of investment banks with respect to managing risks. This means funds of hedge funds are hiring executives with sell-side trading experience so they can develop effective portfolio hedging structures internally. This way the fund only needs investment banks for best execution.

Funds of hedge funds emerged from the general asset management business, where experience in portfolio construction was often enough to give investors comfort that their capital was likely to be well preserved. But this has changed since the crisis.

Meanwhile, investors and managers are adopting a more "systematic, macro" approach in assessing the credit risks of their banking counterparties, Janjusevic says. Credit measures such as the bank's credit default swap (CDS) spreads, their implied volatility levels as reflected by their options, are being monitored by investors when deciding whether a particular US firm is any riskier as a counterparty than, say, a European house, or vice versa.

For the past month volatility has spiked across the equity, foreign exchange and gold markets. For example, the ‘fear gauge' Vix index, which measures the expected volatility of the S&P 500 during the next 30 days, on May 20 spiked to 45.79, its highest level this far this year, as the eurozone sovereign debt concerns and uncertain geo-political issues surrounding North and South Korea have compounded investors' worries over the global economic outlook.

Janjusevic says investors and managers are taking these volatility measures seriously and are ready to move assets out from one prime broker's account to another once a bank's credit spreads spike, or the bank's out-of-the-money (OTM) put options are becoming expensive. If an OTM put is priced at a higher implied volatility level than its OTM call, it might indicate the market's bias towards the downside risks of the bank's stock. Janjusevic says the volatility skew of a bank's options are often closely correlated with the movement of its CDS spread.

Meanwhile, another chief risk officer at a Singapore-based hedge fund that runs relative value strategies says that, after the collapse of Lehman Brothers, there has been an increasing focus by managers to spend more time negotiating the various assumptions they use in their respective stress tests when the manager and its prime broker are negotiating equity financing terms.

He says hedge fund managers are aware of the need to set the appropriate parameters within which they set their margin rate and other collateral terms at the start of their relationship when the two sides settle on a prime brokerage agreement. These parameters are re-visited in the stress tests on an ongoing basis, rather than reviewing them when a crisis hits only to find those parameters were overexposing either party to credit risks.

Time and effort spent at the outset of their relationship is important to avoid a sudden change of credit terms extended by the banks, as witnessed in the case of Lehman Brothers' collapse in 2008, when many hedge fund managers got their credit lines pulled by the banks as the latter were themselves facing a liquidity crunch in the interbank market.