Excerpted from the book Hedge Funds Demystified by Scott Paul Frush
Hedge Fund Hazards, Hurdles, and Hassles
As many investors know and the media never misses an opportunity to point out, there are many pitfalls with investing in hedge funds. Unfortunately, there are a number of risks, both fund-specific risks and industry-specific risks, investors need to be aware of and attempt to avoid. Both categories of risk play an important role in the preservation and growth of your hedge fund investment and should be understood before you make your initial investment contribution. I will begin the discovery of hedge fund risks with fund-specific risks and then transition to industry-specific risks
Hedge fund risks
Fund-Specific Risks
As with any other investment, hedge funds posses different types of investment-specific risk. Each investment has general risks, such as market, industry, and political. However, hedge funds do have some unique risks unto themselves. These risks include operational risk, fraud risk, regulatory risk, transfer risk, settlement risk, credit risk, legal risk, and liquidity risk. Depending on the hedge fund and the type of strategy used, an investor may be confronted with a couple of these risks or many of them. Moreover, the degree of risk also can differ from hedge fund to hedge fund. Each of these risks is explored below.
OPERATIONAL RISK
Operational risk refers to the hedge fund company and the risks associated with not being able to manage the hedge fund properly. This risk is not related to the risk of market value loss or to losses arising from credit or counterparty risks. Operational risk, on the other hand, refers to risk owing to human error or risk due to an inadequate administrative system. For example, a hedge fund may accept newly invested capital and then fail to deposit the capital in a timely fashion owing to poor recordkeeping or outright human error. Another example of operational risk is the uncertainty of completing a performance composite and thus having nothing to provide prospects and clients on how well the fund did in the recent calendar year. Operational risk also includes the risk that hedge fund managers may leave the fund to pursue greener pastures with other hedge funds or even to start their own hedge fund. Another significant operational risk relates to technology and systems of a particular hedge fund. For newly established hedge funds, Microsoft Excel and Access are the software applications of choice, driven mostly by necessity. And this is fine, given their relatively small size. However, as a hedge fund grows, the need for more sophisticated software also grows. Without this software, a hedge fund may experience “growing pains.” In summary, this risk is very manageable and should not be a big burden when hedge funds do their jobs properly.
PRICING AND VALUATION RISK
Risk and accounting professionals are typically the people at hedge funds charged with the role of valuing the positions held by the hedge fund and identifying accurate pricing. Making inaccurate valuations is commonplace with money managers for a number of reasons. Most valuation errors are immaterial and “true up,” or self-correct, the very next day when accurate data are used. Errors in valuation can arise from price upload problems, system configuration issues, mismanagement of spreadsheets, deal modeling errors, or simply receiving the wrong prices or no prices. Beyond the more common process-oriented errors, problems with valuation methodology can have a great impact on overall results. There are many moving parts in hedge fund valuation and therefore many pitfalls for error.
FRAUD AND FIDUCIARY RISK
Fraud is perhaps the most serious of all types of hedge fund risk. When investors place their trust in hedge fund managers and invest their capital, they are expecting managers to conduct themselves with integrity. Fraud can bring down an entire hedge fund and hedge fund company. When a hedge fund manager or any other investment manager, for that matter, does not act with integrity, then everyone losses. Chapter 5 on colossal collapses mentions some hedge funds that were victims of fraud and eventually failed after losing millions for investors.
TRANSFER RISK
Transfer risk refers to the restriction of transferring ownership interest from one hedge fund investor to another. Most hedge fund investors are required to liquidate their hedge fund investment directly with the fund itself rather than selling to an existing investor or outside party. Although this risk is marginal, to some investors looking for greater liquidity, it can be quite important.
SETTLEMENT RISK
Settlement risk is the risk that a hedge fund will be unable to finalize a transaction at the terms of the contract agreed to on the purchase trade date. This risk is minimized for exchange-traded instruments but exists with off-exchange instruments. Not settling at agreed-on terms can be costly, create delays, and perhaps require legal or arbitrary means to resolve the issue.
CREDIT RISK
Credit risk refers to the risk inherent in companies in which a hedge fund has an ownership interest. These companies may declare bankruptcy or cease paying bond interest payments owing to challenging financial positions. Since some hedge funds invest in fixed-income securities, there is always the risk that they could default on payments. If this were to happen, then the hedge fund could experience performance challenges. Counterparty credit risk is also grouped under this type of risk. Hedge funds that employ derivative instruments such as swaps will assume greater risk because some counterparties may default on their obligation or challenge the terms of the agreement. For example, two hedge funds enter into a plain-vanilla swap in which one party pays a floating rate of interest, and the counterparty pays a fixed rate of interest. At contract expiration, the floating rate hedge fund party finds itself in the unfortunate position of having to make payment to the fixed-rate party. If this hedge fund were unable or unwilling to meet its obligation to make payment, then the fixed-rate party would lose out. Of course, the fixed-rate party will pursue payment but will incur costs and waste time when the counterparty should have fulfilled the agreement.
LEGAL RISK
Legal risk refers to the risk that a hedge fund will face legal challenges that need the attention of the management team. This risk should not be confused with regulatory risk, which is entirely different. Given the heightened risk with hedge funds, having an investor pursue legal remedies as a result of poor performance is not uncommon. Incurring costs to address nonregulatory legal issues is at the center of this hedge fund risk.
TRANSPARENCY RISK
Over the last few years, hedge funds have greatly improved their overall transparency with regard to asset positions, strategies employed, and performance results. Unfortunately, this was motivated by the need to calm investors during times of substantial financial losses and fund failures. Regulators became more involved and have mandated ever-increasing ways for hedge funds to enhance their transparency. Prior to this time, only select key people knew exactly what was happening with their hedge fund. When hedge funds do not provide adequate transparency, investors make less than optimal decisions, and the consequences can be disastrous. Over time, this risk should abate as more and more hedge funds enhance their transparency to avoid regulatory issues and to attract much desired institutional capital.
LIQUIDITY RISK
Liquidity risk can refer to two things. First, it can refer to the risk where a hedge fund is unable to liquidate an investment at a price close to the present market value. Larger investment positions needing to be sold can be especially challenging. In addition, since some hedge funds invest in relatively illiquid assets, selling those positions could take significant time and effort. Second, liquidity risk can refer to restrictions on withdrawing money from the hedge fund. Most hedge funds have restrictions on when money can be withdrawn, primarily only quarterly and not at all in the first year of the investment. This is an inconvenient provision to some hedge fund investors.
MODEL RISK
Much of risk management begins with what is called value-at-risk, or VaR for short. VaR is a model used to capture and quantify the risks inherent in a business enterprise. Hedge funds use VaR in an attempt to improve their risk-management functions and better operate their hedge funds. VaR, as with any financial model, is susceptible to its inputs. We have all heard of the expression, “Garbage in, garbage out.” Depending on the inputs to VaR, the model may report a risk level that is lower than in actuality, creating a scenario in which the hedge fund manager assumes more risk because he or she believes that there is remaining risk capacity within established risk thresholds. VaR is not the only model that can break down. Many asset-valuation models also can self-destruct with severe consequences. The collapse of the hedge fund Long Term Capital Management can be attributed to model failure precipitated by human error related to the inputs of the model.