FRM Handbook Ch 30: Hedge Fund Risk Management (Hedge Fund Industry and Market Risks)

Book: Financial Risk Manager Handbook Plus Test Bank
Author: Philippe Jorion
ISBN: 978-0-470-90401-5

Hedge funds are the wild cousins of mutual funds. Chapter 30’s first half explains what they are, how big the industry got, and why risk management tools from bank trading desks migrated to Greenwich and Mayfair.

A short history of growth

A.W. Jones started the first hedge fund in 1949, taking long and short equity positions. By December 2009, the industry managed over $1,600 billion in equity capital (assets under management, or AUM). That is up from $40 billion in 1990, an annualized growth rate above 20%. U.S. mutual funds grew from $1,065 billion to $11,121 billion over the same period, but at a slower 13% pace.

Roughly 9,000 hedge fund managers controlled that capital. Because of leverage, the gross assets under control exceeded AUM significantly.

How hedge funds differ from mutual funds

Hedge funds are private partnerships, not public companies. Key differences:

• Access: Limited to accredited investors, not the general public.
• Regulation: Lighter touch than mutual funds.
• Strategies: Long and short, leverage, derivatives, commodities, distressed debt. Few restrictions.
• Fees: Typically “2 and 20” (2% management fee, 20% performance fee).
• Liquidity: Lockup periods and redemption notice requirements, unlike daily mutual fund liquidity.

The flexibility is the product. Investors pay for the chance to earn returns uncorrelated with stock markets, especially during bad years like 2000-2002.

Shorting mechanics and leverage measures

Short selling is central to many strategies. The chapter covers the mechanics: borrow shares, sell them, post collateral, buy back later. Costs include borrow fees, dividend payments to the lender, and margin requirements.

Leverage can be measured several ways:

• Notional leverage: Gross positions divided by NAV.
• Economic leverage: Exposure to risk factors relative to capital.
• Margin leverage: How much borrowing the prime broker allows.

A fund with $1 billion NAV and $5 billion in gross positions has 5:1 notional leverage. That is moderate by hedge fund standards. LTCM ran at 25:1.

Common strategies and their risks

Jorion surveys the major categories:

Equity long/short: Buy undervalued stocks, short overvalued ones. Market exposure depends on net position. Risk factors: equity beta, sector tilts, short squeeze risk.

Equity market neutral: Matched long and short books designed for zero beta. Profits come from stock selection. Risk: model breakdown, crowded trades in similar factors.

Fixed-income arbitrage: Exploit small yield discrepancies with high leverage. Low returns per trade, so leverage amplifies thin edges. Liquidity risk is the killer.

Convertible arbitrage: Long convertible bonds, short underlying equity. Exposed to credit, equity, volatility, and liquidity.

Distressed securities: Buy debt of troubled companies. Illiquid, long holding periods, high idiosyncratic risk.

Global macro: Large directional bets on currencies, rates, commodities. High conviction, high volatility.

Managed futures/CTAs: Trend-following in futures markets. Positive skew in some periods, sharp drawdowns when trends reverse.

Each strategy maps to a set of risk factors. The risk manager’s job is to identify which factors the fund is actually exposed to, not just what the marketing deck says.

Why hedge funds adopted VaR

Hedge fund strategies overlap heavily with bank proprietary trading. It was natural to adopt similar tools: position limits, VaR, stress testing, scenario analysis. Most larger funds run daily risk reports by the mid-2000s.

The catch is that standard VaR works better for liquid, linear positions. It struggles with illiquid distressed debt, complex structured products, and nonlinear optionality.

What stuck with me

The industry overview is dated in the numbers (2009 AUM) but the structure is current. Hedge funds still operate as private partnerships with leverage, lockups, and incentive fees.

The strategy taxonomy is the useful part for risk work. You cannot measure what you have not classified. A “multistrategy” fund label tells you almost nothing. Mapping positions to factor exposures tells you everything.

Previous: FRM Handbook Ch 29: Portfolio Risk Management
Next: FRM Handbook Ch 30: Hedge Fund Risk Management (Specific Risks and Transparency)