Riskology: What money markets can teach hedge funds

Hedge funds can benefit from understanding how vehicles they use for cash management manage liquidity risk and perform stress tests

Hedge funds have regularly been at the forefront of innovation when it comes to investing strategies, alpha generation, asset class creation and risk management. Part of that innovation comes from adopting practices and analysis from other fields, and it is in that spirit that I claim hedge funds can benefit from understanding the practices of an investment vehicle they themselves use for cash management: money markets. Recent updates to the regulations governing these funds are directly applicable to hedge fund risk management, and offer improvements in ways to manage liquidity risk and perform simultaneous stress tests.

Five years ago, the US Securities and Exchange Commission (SEC) adopted new requirements in its 2a-7 regulations governing US money market funds, which historically had a $1 stable net asset value (NAV) structure, unlike money markets in Europe where the NAV floats day to day. Those new regulations, coming on the heels of the global financial crisis and the collapse of Lehman Brothers, were meant to give the managers of such funds the tools to ensure they can continue to meet redemption requests at the $1 NAV level. Failure to do so is known as ‘breaking the buck' and typically results in the demise of the fund. Among the new regulations was a set of stress tests that closely resembled what some of our hedge fund clients had been doing for years, but these stress tests required simultaneous multi-dimensional stresses.

Specifically, they require the funds to stress interest rates, credit spreads and liquidity/redemption requests to the point of breaking the buck, defined as not being within 0.5% of the target $1 price. Their logic is sound: unless you actually go to the breaking point, how can you know how safe or how much danger your fund is in? This is a very engineering-like approach, in which a sample material is tested to its physical breaking point to ensure that the force required to break it is well outside the expected real-life load. With money market funds, they are required to simulate how the combination of rates, spreads and redemptions might bring their fund NAV to below the point of breaking the buck. While they are required to stress each of those dimensions separately, the more realistic stresses are those that simultaneously move the three dimensions to see what combinations of interest rate move, credit spread changes and redemption requests would, in fact, cause the fund to break the buck.

Figure 1 shows a topographical map-style representation of such a 3D stress. Credit and interest rate changes are shown on the vertical and horizontal axes, and the entire sheet is calculated for a particular level of redemption – in this case, for 30% of the investors demanding withdrawals. The grey box in the center shows the value of the fund with no changes in any of the stressed variables and is clearly in the white ‘safe zone' while other cells show the fund NAV for its particular combination of interest rate and credit spread value. The colour coding can be interpreted as topographical: the downhill yellow ‘warning track' and the red cliff, where the fund breaks the buck. At every point, the fund managers know just how far – or close – they are to falling off the cliff.

The application to floating rate money markets and to hedge funds is clear: by defining an appropriate threshold as an equivalent breaking point, the fund can simultaneously stress the relevant factors for its investment types to that breaking point. Knowing what combinations of market factor movements would cause such catastrophic harm is clearly of value to the risk management process, yet few hedge funds do it this way. An additionally interesting way for hedge funds to perform such multi-dimensional stresses is to do so while preserving correlation: rather than consider all possible combinations of different stress levels, a hedge fund could focus on those combinations which are consistent with current or expected correlations.

The same redemption risk that affects money funds can impact hedge funds: matching investor redemption requests with liquidation of assets is a universal function of portfolio managers. By creating a risk sheet, like the one shown in Figure 1, for each level of redemption, a hedge fund can more easily manage its own liquidity risk.

Updated requirements

The SEC recently updated its 2a-7 stress testing requirements and mandated that US institutional investor money market funds adopt a floating NAV, while retail money market funds continue to use a $1 NAV structure. The modified stress tests add liquidity measurement requirements and meaningful grouped security default simulations. The application to hedge funds is again, straightforward. Rather than stressing all securities, hedge funds can stress certain sectors independent of others. For example: all stocks, bonds and derivatives of a given issuer or sector; securities denominated in specific currencies; or securities tied to specific strategies or sectors. Our own multi-dimensional stress engine allows hedge funds to stress any number of factors, such as equity prices, yields, volatilities, commodities, foreign exchange rates or credit spreads, and they can do so independently or in any combination.

Liquidity is an especially interesting case in that the SEC requires each fund to maintain pre-defined levels of "weekly liquid assets" (WLA) of at least 15% of the fund. To meet redemption requests, fund managers must choose which securities to sell to provide the cash flow while maintaining at least the minimum required WLA level. By simulating different selling approaches such as ‘sell liquid securities first' or ‘sell off losing positions first', the manager can determine which strategy best preserves NAV and the fund's WLA. Hedge funds might add other requirements such as also preserving a certain hedging ratio.

The requirements around simulating defaults are also directly applicable to hedge funds. In this case, the SEC requires money market funds to downgrade/default individual securities and groups of securities by simulating increasingly poor recovery rates to see the impact on fund value, liquidity profile and risk profile. Because money market funds are mainly invested in fixed-income securities, the SEC's focus is on defaults. But with investments across asset classes, hedge funds can perform such stresses in a more free-form style, simulating individual shocks in FX, commodity, equity and fixed-income markets to assess their individual and combined impacts on the fund's value, liquidity and risk profiles.

Cross-fertilisation of ideas is a hallmark of innovation, and learning from others is an efficient way of improving our own practices. While it may seem strange to voluntarily adopt a regulator's requirements for a different part of the financial services industry, I believe that the SEC's money market stress tests present a thoughtful approach to practical risk management so that the manager of a money market fund or hedge fund has better foresight of possibly damaging scenarios and increased time to react. These analyses can help fund managers make better risk decisions.

Damian Handzy is chief executive of Investor Analytics.