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Characterise the criteria by which a hedge fund's risk management process can be assessed.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.d

The idea

A hedge fund's risk management process is judged on whether risk is identified, measured, limited, reported and acted on, by a function that is independent of the portfolio manager. Measurement should cover market risk through VaR and stress tests, plus leverage, gross and net exposure, concentration, liquidity and counterparty risk. There should be written limits with an escalation path and evidence they are enforced. The risk officer should report outside the trading line, with authority to force position reductions. Investors also check that the manager understands the limits of its models, backtests them, and gives enough transparency for investors to see the exposures. The common mistake is accepting a reported VaR number as proof of risk management. The exam point is independence plus use in decisions, not the existence of a number.

Formulas

Gross exposure of a hedge fund

Gross = (Long + Short) ÷ NAV

Long
the value of long positions
Short
the absolute value of short positions
NAV
the fund's net asset value

Gross measures leverage, so shorts are added, not netted. It says nothing about direction, which is the net exposure.

Net exposure of a hedge fund

Net = (Long − Short) ÷ NAV

Long
the value of long positions
Short
the absolute value of short positions
NAV
the fund's net asset value

Net measures directional market exposure. A low net figure can sit beside high gross leverage, so read both.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature most clearly indicates that a hedge fund's risk function is independent?

  1. The risk officer is a close friend of the portfolio manager and was hired and is paid by himWhy not: Personal closeness and hiring by the portfolio manager are the opposite of independence.
  2. The risk report is produced daily by the portfolio manager's own teamWhy not: Frequent reporting by the trading team is not independence.
  3. The fund's VaR is calculated with a vendor's software packageWhy not: Using a vendor tool addresses measurement, not who controls and enforces risk limits.
  4. The risk officer reports outside the trading line and can force position cuts - correct

Independence means the risk function can act without the portfolio manager's approval. Without authority to cut positions, measurement alone does not control risk.

A harder one

Which observation best suggests that a manager's risk limits are not effective?

  1. Limit breaches are approved by the portfolio manager without escalation - correct
  2. Limits are reviewed and updated annually by the risk committeeWhy not: Periodic review is good practice and shows that limits are maintained.
  3. Risk reports are delivered to the investors monthlyWhy not: Regular reporting supports transparency and is not a sign of ineffective limits.
  4. The limits are set in the fund's written risk policyWhy not: Written limits are a positive; ineffectiveness shows in enforcement.

Limits only work if breaches are escalated to someone independent. Self-approval of breaches by the person who takes the risk defeats the control.

The hardest tier

A fund has NAV of USD 400 million, long positions of USD 520 million and short positions of USD 330 million. An investor wants to verify the manager's exposure reporting. Which pair of figures is correct?

  1. Gross exposure 130% of NAV and net exposure 47.5% of NAVWhy not: Takes gross exposure as the long book only, ignoring the shorts.
  2. Gross exposure 212.5% of NAV and net exposure 212.5% of NAVWhy not: Treats net exposure as the sum of long and short, which is gross exposure.
  3. Gross exposure 47.5% of NAV and net exposure 212.5% of NAVWhy not: Swaps the two measures: net is long minus short, gross is long plus short.
  4. Gross exposure 212.5% of NAV and net exposure 47.5% of NAV - correct

Gross = (520 + 330) / 400 = 212.5%. Net = (520 - 330) / 400 = 47.5%. Gross measures leverage, net measures directional exposure.

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