- RISK ANALYSIS -- RISK ANALYSIS -

A PERSPECTIVEA PERSPECTIVE

APPROACHAPPROACH

FINANCIAL RISKFINANCIAL RISK

COVERAGE COVERAGE

• What is financial riskWhat is financial risk

• Financial risk management definedFinancial risk management defined

• Risk Management for Hedge FundsRisk Management for Hedge Funds

Hedge Fund Managers Perspective Hedge Fund Managers Perspective Institutional Investors Perspective Institutional Investors Perspective

• Types of Hedge Fund RiskTypes of Hedge Fund Risk

• Issues associated with the investment processIssues associated with the investment process - A investors perspective of risk assessment -- A investors perspective of risk assessment -

• What is Financial Risk?What is Financial Risk?

Financial risk is uncertainty in financial Financial risk is uncertainty in financial transactions undertaken by the firm. This transactions undertaken by the firm. This uncertainty is in the form of future financial uncertainty is in the form of future financial abilities of the issuer to pay stockholders and abilities of the issuer to pay stockholders and creditor’s principal and interest.creditor’s principal and interest.

• Financial Risk Management Defined: Financial Risk Management Defined:

An assessment of the possibility that a given An assessment of the possibility that a given investment or loan will fail to bring a return and investment or loan will fail to bring a return and may result in a loss of the original investment or may result in a loss of the original investment or loan and take the measures to minimize or loan and take the measures to minimize or reduce the risk probabilities associated with the reduce the risk probabilities associated with the investment decision which the firm make on investment decision which the firm make on behalf of investors to earn for them the behalf of investors to earn for them the expected returns. expected returns.

Despite ongoing concerns about the lack of transparency and Despite ongoing concerns about the lack of transparency and potential instabilities of hedge fund investment companies, the potential instabilities of hedge fund investment companies, the hedge fund industry continues to grow at a rapid pace which is hedge fund industry continues to grow at a rapid pace which is evident from the asset size under management to the tune of evident from the asset size under management to the tune of US $ 1.13 trillion. US $ 1.13 trillion.

Unlike equities, fixed income instruments, and real estate–asset Unlike equities, fixed income instruments, and real estate–asset classes each defined by a common set of legal, institutional, and classes each defined by a common set of legal, institutional, and statistical properties–“alternative investments” is a mongrel statistical properties–“alternative investments” is a mongrel categorization that includes private equity, risk arbitrage, categorization that includes private equity, risk arbitrage, commodity futures, convertible bond arbitrage, emerging commodity futures, convertible bond arbitrage, emerging market equities, statistical arbitrage, foreign currency market equities, statistical arbitrage, foreign currency speculation, and many other strategies, securities, and styles.speculation, and many other strategies, securities, and styles.

Therefore, the need for a set of risk management protocols Therefore, the need for a set of risk management protocols specifically designed for hedge fund investments has never specifically designed for hedge fund investments has never been more pressing. Part of the gap between institutional been more pressing. Part of the gap between institutional investors and hedge fund managers is the very different investors and hedge fund managers is the very different perspectives that these two groups have on the investment perspectives that these two groups have on the investment process. process.

SCENARIO OF HEDGE FUND INDUSTRY

Manager and Institutional Investors – Risk PerspectivesManager and Institutional Investors – Risk Perspectives

Manager Manager Institutional Investors Institutional Investors

Desecration in investment decisions. Desecration in investment decisions. Understanding of the investment Understanding of the investment process and the risk is very important. process and the risk is very important.

Strategy is highly proprietary and Strategy is highly proprietary and mangers intellectual property so no mangers intellectual property so no much disclosure.much disclosure.

Not only the return other factors also Not only the return other factors also counts e.g. risk management, counts e.g. risk management, performance against the benchmark, performance against the benchmark, peer comparison etc. peer comparison etc.

Return is the ultimate objectives and Return is the ultimate objectives and purpose.purpose.

Risk management and the Risk management and the transparency are critical factors.transparency are critical factors.

General partner is the fund. General partner is the fund.

They should know the investment They should know the investment process very well as this class have to process very well as this class have to comply with the various state and comply with the various state and fiscal laws. fiscal laws.

Regulators are the hurdles in the Regulators are the hurdles in the performance. performance.

Risk management is not central or Risk management is not central or much of the importance. much of the importance.

Variety of risk management techniques are been used by the Variety of risk management techniques are been used by the hedge fund managers and the respective class of investors hedge fund managers and the respective class of investors while doing the business and investing respectively. Some of while doing the business and investing respectively. Some of them are as follows: them are as follows:

• Value at RiskValue at Risk • Risk Metrics Risk Metrics • Convexity Convexity

• BetaBeta • LeveragesLeverages

It is to be remembered that the alternative investment like It is to be remembered that the alternative investment like hedge funds are not suitable for all investors, one should know hedge funds are not suitable for all investors, one should know his own risk appetite and then only opt for such type of his own risk appetite and then only opt for such type of investment alternative. investment alternative.

RISK MEASUREMENT TECHNIQUES

RISK – TYPES RISK – TYPES Liquidity Risk:Liquidity Risk: Liquidity risk arises on the assets side, when the positions cannot be Liquidity risk arises on the assets side, when the positions cannot be

liquidated quickly without incurring transaction costs. It also arises on liquidated quickly without incurring transaction costs. It also arises on the liabilities side, either from the leverage (debt), or from potential the liabilities side, either from the leverage (debt), or from potential investor redemptions (equity). Typically, funds with greater asset investor redemptions (equity). Typically, funds with greater asset liquidity risk impose longer lockup periods for investors in order to liquidity risk impose longer lockup periods for investors in order to balance liquidity risk on both sides of their balance sheet. balance liquidity risk on both sides of their balance sheet.

   On the asset side, liquidity risk is a function of the size of the positions On the asset side, liquidity risk is a function of the size of the positions

as well as of the price impact of a given size trade for the instrument. as well as of the price impact of a given size trade for the instrument. Some categories of hedge funds have intrinsic liquidity risk because the Some categories of hedge funds have intrinsic liquidity risk because the instruments they use are thinly traded, implying a large price impact for instruments they use are thinly traded, implying a large price impact for most trades. This is the case with convertible bonds or distressed most trades. This is the case with convertible bonds or distressed securities. In this case, liquidity risk arises even for small funds. Liquidity securities. In this case, liquidity risk arises even for small funds. Liquidity risk, however, is also an issue when the fund positions grow very large, risk, however, is also an issue when the fund positions grow very large, even in liquid markets. even in liquid markets.

   Liquidity risk is difficult to factor into the usual value-at-risk (VAR) Liquidity risk is difficult to factor into the usual value-at-risk (VAR)

models. Usually, VAR models loosely account for liquidity risk by models. Usually, VAR models loosely account for liquidity risk by extending the horizon for less liquid assets. This is a totally extending the horizon for less liquid assets. This is a totally ad hocad hoc approach, however. Accounting for potential losses due to asset approach, however. Accounting for potential losses due to asset liquidation requires a price impact function, which is difficult to liquidation requires a price impact function, which is difficult to estimate. Optimal liquidation strategies should balance the direct cost of estimate. Optimal liquidation strategies should balance the direct cost of fast liquidation against the risk of keeping open positions. fast liquidation against the risk of keeping open positions.

Liquidity Risk Cont.Liquidity Risk Cont.

Instrument liquidity risk creates another Instrument liquidity risk creates another problem which is that of stale prices. Say that problem which is that of stale prices. Say that the reporting period for net asset values (NAV) the reporting period for net asset values (NAV) is the end of each month. If transaction prices is the end of each month. If transaction prices are not observed at the end of the month, the are not observed at the end of the month, the valuation may be using a price from a trade valuation may be using a price from a trade that occurred in the middle of the month, that occurred in the middle of the month, creating measurement errors in the reported creating measurement errors in the reported NAVs. This is a minor nuisance, but does not NAVs. This is a minor nuisance, but does not necessarily create a systematic bias in the necessarily create a systematic bias in the NAVs. Investors, however, should make sure NAVs. Investors, however, should make sure the hedge fund manager is not manipulating the hedge fund manager is not manipulating asset values to overstate the fund’s asset values to overstate the fund’s performance. performance.

Market Risk: Market Risk:

Market risk is exposure to the uncertain market value of a Market risk is exposure to the uncertain market value of a portfolio. A trader holds a portfolio of commodity forwards. He portfolio. A trader holds a portfolio of commodity forwards. He knows what its market value is today, but she is uncertain as to knows what its market value is today, but she is uncertain as to its market value a week from today. Market risk is the inherent its market value a week from today. Market risk is the inherent in case of the trading into the financial markets but the hedge in case of the trading into the financial markets but the hedge funds are known for their market neutral strategies which try to funds are known for their market neutral strategies which try to isolate their own product portfolio from the market direction.isolate their own product portfolio from the market direction.

Market risk is managed with a short-term focus. Long-term Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a On a tactical level, traders and portfolio managers employ a variety of risk metrics —duration and convexity, the Greeks, variety of risk metrics —duration and convexity, the Greeks, beta, etc.—to assess their exposures. These allow them to beta, etc.—to assess their exposures. These allow them to identify and reduce any exposures they might consider identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage excessive. On a more strategic level, organizations manage market risk by applying risk limits to traders' or portfolio market risk by applying risk limits to traders' or portfolio managers' activities. Increasingly, value-at-risk is being used to managers' activities. Increasingly, value-at-risk is being used to define and monitor these limits. Some organizations also apply define and monitor these limits. Some organizations also apply stress testing to their portfolios. stress testing to their portfolios.

Credit Risk: Credit Risk:

Credit risk is risk due to uncertainty in a counterparty's (also Credit risk is risk due to uncertainty in a counterparty's (also called an obligor's or credit's) ability to meet its obligations. called an obligor's or credit's) ability to meet its obligations. Because there are many types of counterparties—from Because there are many types of counterparties—from individuals to sovereign governments—and many different individuals to sovereign governments—and many different types of obligations—from auto loans to derivatives transactionstypes of obligations—from auto loans to derivatives transactions—credit risk takes many forms. Institutions manage it in —credit risk takes many forms. Institutions manage it in different ways.different ways.

In assessing credit risk from a single counterparty, an institution In assessing credit risk from a single counterparty, an institution

must consider three issues: must consider three issues:

Default probabilityDefault probability:: What is the likelihood that the What is the likelihood that the counterparty will default on its obligation either over the life counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a of the obligation or over some specified horizon, such as a year? Calculated for a one-year horizon, this may be called year? Calculated for a one-year horizon, this may be called the expectedthe expected defaultdefault frequency.frequency.

CreditCredit exposureexposure:: In the event of a default, how large will the In the event of a default, how large will the outstanding obligation be when the default occurs? outstanding obligation be when the default occurs?

RecoveryRecovery raterate:: In the event of a default, what fraction of the In the event of a default, what fraction of the exposure may be recovered through bankruptcy exposure may be recovered through bankruptcy proceedings or some other form of settlement?proceedings or some other form of settlement?

Market Neutral Strategies – A Risk Market Neutral Strategies – A Risk

PerspectivePerspective U.S. Equity Market Neutral strategies are viewed to be among the U.S. Equity Market Neutral strategies are viewed to be among the most straightforward and easily understandable types of hedge most straightforward and easily understandable types of hedge fund. These strategies are designed to take advantage of the fund. These strategies are designed to take advantage of the spread between returns of attractive stocks (on the long side) and spread between returns of attractive stocks (on the long side) and unattractive stocks (on the short side). A manager's ability to unattractive stocks (on the short side). A manager's ability to capture this spread is a function of stock selection skill as well as capture this spread is a function of stock selection skill as well as other lesser known or understood considerations.other lesser known or understood considerations.

Investors are increasingly turning to hedge funds in an effort to Investors are increasingly turning to hedge funds in an effort to maintain satisfactory returns while reducing portfolio volatility. maintain satisfactory returns while reducing portfolio volatility. Hedge funds typically are highly Hedge funds typically are highly uncorrelateduncorrelated with traditional with traditional asset classes and therefore provide good diversification benefits asset classes and therefore provide good diversification benefits along with the potential for very strong investment returns. Long-along with the potential for very strong investment returns. Long-short market neutral U.S. equity strategies are among the more short market neutral U.S. equity strategies are among the more popular hedge funds for achieving this goal. These strategies popular hedge funds for achieving this goal. These strategies typically use stock selection to capture excess returns while typically use stock selection to capture excess returns while targeting a beta exposure of zero. By investing both long and targeting a beta exposure of zero. By investing both long and short, the manager can neutralize market exposure while short, the manager can neutralize market exposure while doubling the potential for excess return. Investors find varied doubling the potential for excess return. Investors find varied uses for long-short market neutral strategies within their uses for long-short market neutral strategies within their portfolios.portfolios.

Broadly, there are some misperceptions that follow Broadly, there are some misperceptions that follow the strategy. One is the opinion that long-short the strategy. One is the opinion that long-short market neutral strategies somehow provide a free market neutral strategies somehow provide a free lunch because of the double alpha, or return, of the lunch because of the double alpha, or return, of the strategy. What is often forgotten is the double strategy. What is often forgotten is the double omega, or active risk, associated with the strategy. omega, or active risk, associated with the strategy. This means that while a skilled manager may have This means that while a skilled manager may have double the positive value-added, an unskilled double the positive value-added, an unskilled manager may have double the negative value-added.manager may have double the negative value-added.

When evaluating market neutral strategies these When evaluating market neutral strategies these misconceptions and other potential risks need to be misconceptions and other potential risks need to be understood and explored rigorously. Generally, the understood and explored rigorously. Generally, the risks fall into four categories: investment process, risks fall into four categories: investment process, implementation, personnel, and firm.implementation, personnel, and firm.

Market Neutral Strategies – Risk FactorsMarket Neutral Strategies – Risk Factors

Market NeutralMarket Neutral StrategiesStrategies

– – Risk Factors -Risk Factors -

InvestmentInvestmentProcessProcess

ImplementationImplementation Personnel

FirmFirm

Issues Associated with Investment Process: Issues Associated with Investment Process:

The Manager's JudgmentThe Manager's Judgment

The greatest risk for a long-short market neutral strategy is that the The greatest risk for a long-short market neutral strategy is that the source of return will vanish. Ultimately, the success of most long-short source of return will vanish. Ultimately, the success of most long-short market neutral strategies comes down to stock selection. Therefore, if market neutral strategies comes down to stock selection. Therefore, if the stock ranking process is invalidated, the manager's edge is gone. the stock ranking process is invalidated, the manager's edge is gone. Over the years, managers have experienced periods when their process Over the years, managers have experienced periods when their process was "out of favor" in times when market conditions or structure had was "out of favor" in times when market conditions or structure had changed. Sometimes these changes reversed and the approach changed. Sometimes these changes reversed and the approach returned to favor, sometimes they did not.returned to favor, sometimes they did not.

Changes in Market StructureChanges in Market Structure

Changes to market structure can also be an impediment to manager Changes to market structure can also be an impediment to manager success. For example, the emergence of new industries needs to be success. For example, the emergence of new industries needs to be taken into account because as they grow, maintaining neutrality to taken into account because as they grow, maintaining neutrality to them becomes an issue. Consider the rise of the Internet industry. them becomes an issue. Consider the rise of the Internet industry. Companies now classified as Internets were previously in market Companies now classified as Internets were previously in market segments as diverse as financial services, media and computer segments as diverse as financial services, media and computer hardware. Because they looked expensive relative to their then industry hardware. Because they looked expensive relative to their then industry counterparts, many long-short market neutral funds held them short. In counterparts, many long-short market neutral funds held them short. In aggregate this left the strategy short the Internet industry at precisely aggregate this left the strategy short the Internet industry at precisely the wrong time. Bringing them together into the same industry allowed the wrong time. Bringing them together into the same industry allowed for the comparison of like companies. The same experience is occurring for the comparison of like companies. The same experience is occurring with genomics companies. These had been classified in the drug with genomics companies. These had been classified in the drug industry, but they are behaving differently from the more traditional industry, but they are behaving differently from the more traditional drug companies and should be reclassified into their own industry. drug companies and should be reclassified into their own industry.

Business CategorizationBusiness Categorization

The phenomenon goes beyond just identifying new industries. It is also important The phenomenon goes beyond just identifying new industries. It is also important to understand a company's business in order to insure the appropriate industry to understand a company's business in order to insure the appropriate industry classification. Corning exemplifies this matter as it began in the late 1800's as classification. Corning exemplifies this matter as it began in the late 1800's as Corning Flint Glass, a consumer products company. Consumer products remained Corning Flint Glass, a consumer products company. Consumer products remained an appropriate category for this company until, in 1971, it developed optical fiber an appropriate category for this company until, in 1971, it developed optical fiber that enables voice, video and data to be sent via lasers. This was a fundamental that enables voice, video and data to be sent via lasers. This was a fundamental shift in the company's business that was not reflected immediately in its industry shift in the company's business that was not reflected immediately in its industry classification. The bottom-line is that businesses and industries emerge and classification. The bottom-line is that businesses and industries emerge and change, and investment managers must be aware of these changes in order to be change, and investment managers must be aware of these changes in order to be successful.successful.

Incomplete Information and ValuationIncomplete Information and Valuation

As we look to the future there are many areas that could influence a manager's As we look to the future there are many areas that could influence a manager's ability to add value. One example involves the relationship between investment ability to add value. One example involves the relationship between investment bankers and brokerage houses. Will polluted information flow into the market from bankers and brokerage houses. Will polluted information flow into the market from brokers who are swayed by business conducted on the other side of the Chinese brokers who are swayed by business conducted on the other side of the Chinese wall? Another example is the ongoing concern about the quality of earnings and wall? Another example is the ongoing concern about the quality of earnings and cash flow information. Do they really reflect the value of the company or are they cash flow information. Do they really reflect the value of the company or are they misleading as a result of pension accounting and options? misleading as a result of pension accounting and options?

In conclusion, managers must be aware of the influences on their approach, from In conclusion, managers must be aware of the influences on their approach, from accounting manipulations to changes in industry structure and take steps to accounting manipulations to changes in industry structure and take steps to manage these exposures including incorporating dynamic approaches to stock manage these exposures including incorporating dynamic approaches to stock selection, portfolio construction and industry classifications. The key to success is selection, portfolio construction and industry classifications. The key to success is staying ahead of the curve and investors must take care to identify the manager staying ahead of the curve and investors must take care to identify the manager who can accomplish this. who can accomplish this.

A final, though often overlooked, area of investment process risk goes beyond A final, though often overlooked, area of investment process risk goes beyond individual managers. Investors should be aware of how their long-short managers individual managers. Investors should be aware of how their long-short managers generate their excess returns and whether all use the similar techniques. If that is generate their excess returns and whether all use the similar techniques. If that is the case, diversification of process risk is called for within their alternatives the case, diversification of process risk is called for within their alternatives category. category.

Implementation:Implementation:

Correctly selecting stocks is only half the job when it comes to Correctly selecting stocks is only half the job when it comes to managing long-short market neutral strategies. Implementation holds managing long-short market neutral strategies. Implementation holds additional challenges for the manager and additional considerations for additional challenges for the manager and additional considerations for the investor. First, there are the issues of liquidity, capacity and ability the investor. First, there are the issues of liquidity, capacity and ability to borrow, and then there are those related to interaction with prime to borrow, and then there are those related to interaction with prime brokers and traders. brokers and traders.

Implementation RisksImplementation Risks

Capacity, liquidity and ability to borrow risks are other areas that Capacity, liquidity and ability to borrow risks are other areas that investors should evaluate when considering long-short market neutral investors should evaluate when considering long-short market neutral managers. A major factor in long-short market neutral strategies is lack managers. A major factor in long-short market neutral strategies is lack of capacity on the short side. Capacity constraints arise, as with small of capacity on the short side. Capacity constraints arise, as with small cap strategies, as a result of the stock universe and fund size. In cap strategies, as a result of the stock universe and fund size. In addition, liquidity may affect the portfolio manager's ability to addition, liquidity may affect the portfolio manager's ability to implement the strategy if the fund is either so large that it cannot short implement the strategy if the fund is either so large that it cannot short positions in the necessary size or if it needs to short positions that are positions in the necessary size or if it needs to short positions that are not in good supply (generally in the small cap range). not in good supply (generally in the small cap range).

Along with liquidity, it may be difficult to borrow certain securities, Along with liquidity, it may be difficult to borrow certain securities, especially names that are not typically found in large institutional especially names that are not typically found in large institutional funds. The bulk of institutional equity assets, which form the lion's funds. The bulk of institutional equity assets, which form the lion's share of security lending assets, are invested in large cap companies. share of security lending assets, are invested in large cap companies. By identifying an appropriate inevitable universe, investment managers By identifying an appropriate inevitable universe, investment managers can avoid many of the issues of capacity, liquidity and ability to borrow can avoid many of the issues of capacity, liquidity and ability to borrow within their long-short market neutral strategies.within their long-short market neutral strategies.

Broker SelectionBroker Selection

Selection of the prime broker is an important decision because the Selection of the prime broker is an important decision because the prime broker plays an integral role in the day to day management prime broker plays an integral role in the day to day management of the long-short market neutral process. Criteria for selecting a of the long-short market neutral process. Criteria for selecting a prime broker include their internal and external access to stock on prime broker include their internal and external access to stock on loan, industry experience and resources. First, access to loaned loan, industry experience and resources. First, access to loaned stocks is critical to the effective implementation of the long-short stocks is critical to the effective implementation of the long-short strategy. If a manager cannot short a desired security, there is a strategy. If a manager cannot short a desired security, there is a lost opportunity. Prime brokers should use electronic locates and lost opportunity. Prime brokers should use electronic locates and other techniques to improve implementation. Second, expertise in other techniques to improve implementation. Second, expertise in the operational and management issues associated with long-the operational and management issues associated with long-short strategies is also crucial. Experienced prime brokers are short strategies is also crucial. Experienced prime brokers are often able to help managers avoid potential execution pitfalls. often able to help managers avoid potential execution pitfalls. Third, information management is a significant part of what the Third, information management is a significant part of what the prime broker does; therefore, a strong support structure is prime broker does; therefore, a strong support structure is required. A good prime broker can trouble-shoot potential required. A good prime broker can trouble-shoot potential problems and act quickly when problems arise. They are also problems and act quickly when problems arise. They are also efficient and timely when it comes to reporting. Advanced efficient and timely when it comes to reporting. Advanced technology (including, though not limited to, internet reporting technology (including, though not limited to, internet reporting and trading analytics) is an essential component of this. A final and trading analytics) is an essential component of this. A final consideration is security. In this age of freely flowing information, consideration is security. In this age of freely flowing information, it is important that client data are protected by the prime broker. it is important that client data are protected by the prime broker. Many prime brokers provide individual security identifications to Many prime brokers provide individual security identifications to each member of the portfolio management team to ensure tight each member of the portfolio management team to ensure tight security. security.

Personnel:Personnel:

Personnel risk includes the risk that a manager is not qualified or is Personnel risk includes the risk that a manager is not qualified or is qualified but will leave the firm. Experience and competence are difficult qualified but will leave the firm. Experience and competence are difficult to discern because they are often masked by the aura of age, education, to discern because they are often masked by the aura of age, education, and industry exposure. Although these provide an investor with a level of and industry exposure. Although these provide an investor with a level of comfort, they may not tell the whole story. In today's dynamic comfort, they may not tell the whole story. In today's dynamic environment it may be more important to consider a person's ability to environment it may be more important to consider a person's ability to stay on the leading edge rather than whether they used to be on the stay on the leading edge rather than whether they used to be on the leading edge.leading edge.

Incentives and Personnel LoyaltyIncentives and Personnel Loyalty

Once comfortable with a manager, you need to make sure that person is Once comfortable with a manager, you need to make sure that person is motivated to stay at the firm. A manager will move on if compensation is motivated to stay at the firm. A manager will move on if compensation is not competitive, if the surroundings and corporate culture are not not competitive, if the surroundings and corporate culture are not satisfying or if the future is uncertain - for the firm or the manager. satisfying or if the future is uncertain - for the firm or the manager. Investors can typically get a sense for these issues by asking specific Investors can typically get a sense for these issues by asking specific questions about the compensation structure and the amount of time questions about the compensation structure and the amount of time spent on the road, and it is always useful to visit the manager's site spent on the road, and it is always useful to visit the manager's site during the due diligence process to make an impression about the other during the due diligence process to make an impression about the other issues. Keep in mind, there may be two sides to an issue, particularly issues. Keep in mind, there may be two sides to an issue, particularly compensation. Often it is believed that if managers invest in their own compensation. Often it is believed that if managers invest in their own long-short market neutral portfolio they will work harder to provide excess long-short market neutral portfolio they will work harder to provide excess returns. There may be some positive motivation, but there may also be returns. There may be some positive motivation, but there may also be negative motivation since a manager is more willing to take chances in negative motivation since a manager is more willing to take chances in order to recognize superior returns. If the compensation structure is fair order to recognize superior returns. If the compensation structure is fair and the manager is motivated in other ways, regardless of personal and the manager is motivated in other ways, regardless of personal participation, the manager's objectives should be in line with those of the participation, the manager's objectives should be in line with those of the participants.participants.

Firm:Firm:

The Commitment of the FirmThe Commitment of the Firm

Investors should also look at the investment management firm because the Investors should also look at the investment management firm because the commitment of the firm to the strategy and the structure surrounding it are commitment of the firm to the strategy and the structure surrounding it are critical to its success. Commitment shows in the form of resources to insure critical to its success. Commitment shows in the form of resources to insure leading edge technology, competitive compensation, and resources for leading edge technology, competitive compensation, and resources for investment research. In today's high tech market environment speed and investment research. In today's high tech market environment speed and access to information is vital and without the necessary data, technology and access to information is vital and without the necessary data, technology and hardware investment opportunities may be lost. We've discussed manager hardware investment opportunities may be lost. We've discussed manager compensation, however this is another way that a firm shows its support for the compensation, however this is another way that a firm shows its support for the strategy.strategy.

A Firm's Internal Support Structure A Firm's Internal Support Structure

A solid firm structure is important to support the activities of the portfolio A solid firm structure is important to support the activities of the portfolio management team. This support comes from many areas including management team. This support comes from many areas including sales/marketing support to keep managers focused on day-to-day management sales/marketing support to keep managers focused on day-to-day management instead of asset gathering, operational support to insure readily available instead of asset gathering, operational support to insure readily available portfolio, cash and trading data and, finally, compliance support to assure portfolio, cash and trading data and, finally, compliance support to assure careful monitoring and fulfillment of guidelines. careful monitoring and fulfillment of guidelines.

Structure can also be considered from the perspective of firm size. This Structure can also be considered from the perspective of firm size. This attribute provides benefits that are less visible. Larger firms are typically attribute provides benefits that are less visible. Larger firms are typically regulated more heavily and therefore may exhibit less business risk. regulated more heavily and therefore may exhibit less business risk. Additionally, larger firms have significant bargaining power when it comes to Additionally, larger firms have significant bargaining power when it comes to trading and technology. The brokerage community tends to value prime trading and technology. The brokerage community tends to value prime brokerage and trading relationships with them because of the volume of trading brokerage and trading relationships with them because of the volume of trading generated and therefore they are more responsive and also provide more generated and therefore they are more responsive and also provide more competitive pricing.competitive pricing.

• Long-short market neutral strategies offer many benefits Long-short market neutral strategies offer many benefits relative to traditional management approaches including relative to traditional management approaches including diversification relative to traditional asset classes, attractive diversification relative to traditional asset classes, attractive absolute return and low volatility. To realize these benefits, absolute return and low volatility. To realize these benefits, investors must carefully evaluate their manager choices investors must carefully evaluate their manager choices keeping in mind a variety of considerations including the keeping in mind a variety of considerations including the long-term viability of their investment process, their ability long-term viability of their investment process, their ability to implement the approach, manager qualification and to implement the approach, manager qualification and motivation, and the management firm's strength and motivation, and the management firm's strength and commitment to the strategy. commitment to the strategy.

• Continued growth of the hedge fund industry is only Continued growth of the hedge fund industry is only sustainable if these issues of liquidity and transparency are sustainable if these issues of liquidity and transparency are addressed in one way or another. Investors should be aware addressed in one way or another. Investors should be aware that liquidity risk may be important for some categories of that liquidity risk may be important for some categories of hedge funds and may lead to biases in risk measures. hedge funds and may lead to biases in risk measures. Several methods can be used to correct for these biases. Several methods can be used to correct for these biases. Finally, the development of risk measurement providers Finally, the development of risk measurement providers and funds of funds demonstrates the importance of and funds of funds demonstrates the importance of transparency for hedge funds.transparency for hedge funds.

ConclusionConclusion

OPERATIONAL RISKOPERATIONAL RISK

The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition includes legal risk, which is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. It also includes the exposure to litigation from all aspects of an institution’s activities. The definition does not include strategic or reputational risks.

What is Operational Risk?What is Operational Risk?

Operational risk losses are characterized by seven event

factors associated with:

• Internal fraud: An act of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy, excluding diversity/discrimination events, which involve at least one internal party.

• External fraud:An act of a type intended to defraud, misappropriate property or circumvent the law, by a third party.

• Employment practices and workplace safety: An act inconsistent with employment, health or safety laws or agreements, from payment of personal injury claims, or from diversity/discrimination events.

What is Operational Risk Loss?What is Operational Risk Loss?

• Clients, products, and business practices:An unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product.

• Damage to physical assets:The loss or damage to physical assets from natural disaster or other events.

• Business disruption and system failures:

Disruption of business or system failures.

• Execution, delivery, and process management:Failed transaction processing or process management, from relations with trade counterparties and vendors.

What is Operational Risk Loss? (cont.)What is Operational Risk Loss? (cont.)

Hedge fund managers have long been aware of the need Hedge fund managers have long been aware of the need for investors to conduct thorough due diligence when for investors to conduct thorough due diligence when assessing the merits of their investment strategy. Yet, over assessing the merits of their investment strategy. Yet, over the past few years, there has been an increasing focus on the past few years, there has been an increasing focus on operational due diligence due to:operational due diligence due to:

• The increasing inflows of institutional capital into hedge The increasing inflows of institutional capital into hedge funds.funds.

• Some well publicized fraud cases which have caused Some well publicized fraud cases which have caused losses for even some of the most sophisticated investors losses for even some of the most sophisticated investors in the industry. in the industry.

• Regulators attention because of growth of assets class Regulators attention because of growth of assets class and increasing demand from retail investors and public and increasing demand from retail investors and public pension plans.pension plans.

THE NEED

Institutional investors are increasingly scrutinizing the Institutional investors are increasingly scrutinizing the operational controls and procedures of hedge fund firms. Some operational controls and procedures of hedge fund firms. Some of the items within these five key areas which sophisticated of the items within these five key areas which sophisticated investors and hedge fund managers should focus on are:investors and hedge fund managers should focus on are:

• The experience of operations personnelThe experience of operations personnel

• ComplianceCompliance

• Internal controls and proceduresInternal controls and procedures

• Portfolio pricingPortfolio pricing

• The quality of the service providersThe quality of the service providers

Five Key Operational ConsiderationsFive Key Operational Considerations

• Compulsory appointment of the CEO/CFO to look after Compulsory appointment of the CEO/CFO to look after the operational activities. the operational activities.

• Ownership of operational activities with CEO/CFO Ownership of operational activities with CEO/CFO

• CEO/CFO to ensure sufficiency of operational and CEO/CFO to ensure sufficiency of operational and settlement staff in terms of number and the experience settlement staff in terms of number and the experience

• CEO/CFO to look after operational activities carried on CEO/CFO to look after operational activities carried on by the third party administrator if such activities have by the third party administrator if such activities have been outsourced by the hedge funds. been outsourced by the hedge funds.

• Operations staff main activities would be to scrutinize Operations staff main activities would be to scrutinize the work of the third party service provider in Detail. the work of the third party service provider in Detail.

Experience of Operations PersonnelExperience of Operations Personnel

Existence of the compliance manual to set out the Existence of the compliance manual to set out the compliance policies covering areas like personal trading, compliance policies covering areas like personal trading, trade errors, know your customers etc. trade errors, know your customers etc.

Appointment of a Chief Compliance Officer to oversee Appointment of a Chief Compliance Officer to oversee the compliance function and the execution of the the compliance function and the execution of the compliance policies of the fund.compliance policies of the fund.

The lack of adequate compliance policies and lack of The lack of adequate compliance policies and lack of controls to effectively monitor and enforce such policies, controls to effectively monitor and enforce such policies, may lead to future regulatory fallings.may lead to future regulatory fallings.

ComplianceCompliance

• The adequacy of the firms internal control environment isThe adequacy of the firms internal control environment isjudged by the complexity of the managers investment strategy.judged by the complexity of the managers investment strategy.

• Managers who trade in complex OTC derivative instruments willManagers who trade in complex OTC derivative instruments willneed to ensure, for instance, that there are sufficient backneed to ensure, for instance, that there are sufficient backoffice staff to chase up and review long form confirmations.office staff to chase up and review long form confirmations.

• Where the volumes are large straight through processing is toWhere the volumes are large straight through processing is tobe used while accounting for the transaction to minimize thebe used while accounting for the transaction to minimize themanual intervention. manual intervention.

• Segregation of duties are to be made between the interrelatedSegregation of duties are to be made between the interrelatedfunctions. functions.

• Wire transfers and other asset movements must be tightlyWire transfers and other asset movements must be tightlycontrolled.controlled.

• No manager should allow assets to be moved outside the fundNo manager should allow assets to be moved outside the fundon a single signature and there should be effective segregationon a single signature and there should be effective segregationof duties over cash movementsof duties over cash movements..

Internal Controls and ProceduresInternal Controls and Procedures

• Regulators in US and UK markets increasing their attention Regulators in US and UK markets increasing their attention on industry pricing practices and seeking more on industry pricing practices and seeking more independence of valuation. independence of valuation.

• There is risk of using asset valuations to artificially boost There is risk of using asset valuations to artificially boost the funds performance or to smooth “mark to market” the funds performance or to smooth “mark to market” losses. losses.

• The presence and choice of a third party fund The presence and choice of a third party fund administrator and auditors will be indicative of the administrator and auditors will be indicative of the independence of valuations.independence of valuations.

• If the investment strategy trades in thinly traded or illiquid If the investment strategy trades in thinly traded or illiquid instruments there is inherent valuation risk involved.instruments there is inherent valuation risk involved.

• Investors can reduce valuation risk resulting from poor Investors can reduce valuation risk resulting from poor

operational controls and procedures surrounding the operational controls and procedures surrounding the pricing process, by ensuring that the fund is following pricing process, by ensuring that the fund is following three best practice principles:three best practice principles:

• ValuationValuation transparencytransparency• ConsistencyConsistency• Independent oversightIndependent oversight..

Portfolio PricingPortfolio Pricing

Extent to which the investment manager clearly Extent to which the investment manager clearly communicates to investors the specific methods and communicates to investors the specific methods and processes used to value securities when determining the processes used to value securities when determining the NAV for dealing purposesNAV for dealing purposes

Develop a comprehensive, written Develop a comprehensive, written “Pricing Matrix” “Pricing Matrix” which which describes in detail the specific methods used to value describes in detail the specific methods used to value each type of instrument.each type of instrument.

This pricing policy should be maintained by the third-party This pricing policy should be maintained by the third-party administrator and can normally be made available to administrator and can normally be made available to investors at the direction of the manager.investors at the direction of the manager.

Use of a valuation committee for formal documentation of Use of a valuation committee for formal documentation of the valuation exception which will minute changes to the valuation exception which will minute changes to policy, pricing or exceptions that have been included in policy, pricing or exceptions that have been included in particular NAVs.particular NAVs.

Valuation TransparencyValuation Transparency

• Similar securities to be valued the same way both at a Similar securities to be valued the same way both at a point in time and over time.point in time and over time.

• Equally, if multiple quotes are available, they should be Equally, if multiple quotes are available, they should be averaged in the same way, across all funds managed by averaged in the same way, across all funds managed by the firm, to ensure consistent sampling of market price the firm, to ensure consistent sampling of market price dispersion month-to-month.dispersion month-to-month.

• Source of quotations shall not be “cherry picked” to Source of quotations shall not be “cherry picked” to select the most favorable mark at each month end, (be it select the most favorable mark at each month end, (be it the highest mark, or the sources which best smooth the highest mark, or the sources which best smooth portfolio performance).portfolio performance).

Price ConsistencyPrice Consistency

• Back office should oversee the month end pricing process, Back office should oversee the month end pricing process, rather than front office personnelrather than front office personnel

• It ensures that managers do not mark their own books without It ensures that managers do not mark their own books without back office verification.back office verification.

• Appoint a leading independent third-party administrator who Appoint a leading independent third-party administrator who is tasked with oversight over the month end valuation is tasked with oversight over the month end valuation process.process.

• Best practice calls for the administrator to calculate the Best practice calls for the administrator to calculate the monthly NAV incorporating valuations which are derived monthly NAV incorporating valuations which are derived exclusively from sources independent of the manager.exclusively from sources independent of the manager.

• Such sources includesSuch sources includes brokers, price vendors and third-party brokers, price vendors and third-party valuation agents for complex OTC derivatives.valuation agents for complex OTC derivatives.

An Independent valuation processAn Independent valuation process

• Funds should always be independently audited, preferably by a Funds should always be independently audited, preferably by a “big four” or specialist audit firm with a market reputation for “big four” or specialist audit firm with a market reputation for auditing hedge funds.auditing hedge funds.

• All prime brokers and other counterparties should be high All prime brokers and other counterparties should be high quality financial institutions and there should be transparency in quality financial institutions and there should be transparency in the identities of counterparties that are chosen by the manager. the identities of counterparties that are chosen by the manager.

• The independent third-party administrator plays an extremely The independent third-party administrator plays an extremely important role to protect investor assets by calculating the net important role to protect investor assets by calculating the net asset value of the fund, independent of the manager. asset value of the fund, independent of the manager.

• Note that not all administration work is created equal and Note that not all administration work is created equal and anything less than full service fund administration (i.e. anything less than full service fund administration (i.e. preparation of a complete set of accounting records) increases preparation of a complete set of accounting records) increases operational risk for investors. operational risk for investors.

• Investors in these funds must consider the manager’s reasons Investors in these funds must consider the manager’s reasons and what compensating controls, if any, are present if and what compensating controls, if any, are present if independent oversight over the trading NAV is absent. independent oversight over the trading NAV is absent.

Quality of Service ProvidersQuality of Service Providers

ConclusionConclusion

Operational risk in hedge funds is a potential “time Operational risk in hedge funds is a potential “time bomb” for investors. Investors must increase their bomb” for investors. Investors must increase their focus on this aspect of their investments and not wait focus on this aspect of their investments and not wait for either the regulators or a disaster to alert them to for either the regulators or a disaster to alert them to these risks. Hedge fund investors, while primarily these risks. Hedge fund investors, while primarily focused on their headline risk, should also keep in focused on their headline risk, should also keep in mind that good operational due diligence will help mind that good operational due diligence will help them avoid funds which may suffer a drag on them avoid funds which may suffer a drag on performance due to weak controls, frequent errors or performance due to weak controls, frequent errors or poor internal information. Overall, investors who poor internal information. Overall, investors who consider operational factors will make better informed consider operational factors will make better informed investment decisions and receive more secure investment decisions and receive more secure returns. Chief Investment Officers, Investment returns. Chief Investment Officers, Investment Committees and ultimately Boards of Directors will Committees and ultimately Boards of Directors will take comfort that sufficient attention has been given take comfort that sufficient attention has been given to the operational as well as investment issues within to the operational as well as investment issues within the portfolios under their charge.the portfolios under their charge.

THANK YOU THANK YOU