Risk Due Diligence: How to Spot Hidden Dangers in Hedge Funds

Chapter 10 opens with a Warren Buffett quote: “Risk comes from not knowing what you’re doing.” Hard to argue with that. Travers uses this chapter to walk us through the risk due diligence process, and honestly, some of the findings are pretty eye-opening.

What Even Is Risk?

Travers tries to come up with some fancy definition of risk, but then realizes the simplest one is the best:

Risk = the possibility of something bad happening.

That is it. No complex formulas needed for the definition itself. What makes it useful is that it does not limit you to just looking at numbers. Risk is everywhere in a hedge fund, and it comes in many flavors.

He lists over 20 types of risk that can hit a hedge fund. Here are some of the big ones:

• Asset liquidity - can you actually sell what you own?
• Counterparty - what if your trading partner goes bankrupt (like Lehman)?
• Leverage - how much borrowed money is in play?
• Key person - what happens if the star manager leaves?
• Tail risk - those “once in a century” events that somehow happen every decade
• Liquidity mismatch - can you pay investors back when they want out?
• Reputation - funds that invested in Madoff went out of business just from the association

Here’s the thing. Most of these risks are not something you can measure with a single number. They require judgment, investigation, and asking the right questions.

Visualizing Risk: The Scorecard Approach

Travers creates a simple but effective chart. He scores each risk factor from 1 (low) to 10 (high) for the case study fund FCM. Then he compares those scores against other hedge funds in a peer group.

This is not rocket science, but it works. You can quickly see where a fund stands relative to competitors. A fund might look great on returns but score terrible on counterparty risk or position concentration. One chart and you see the whole picture.

He also references a 2011 industry survey (from Capital Market Risk Advisors) that found only 32 percent of respondents viewed operational risk as a major focus. Given how many hedge fund blowups come from operational failures, that number is surprisingly low. On the positive side, the percentage of firms with formal risk management policies jumped from 60 percent in 2009 to 87 percent in 2011. The 2008 crisis clearly scared people into getting their act together.

Value at Risk (VaR): Useful but Flawed

Travers covers Value at Risk, which is the standard way the industry measures potential losses. VaR tells you the maximum loss you can expect at a certain confidence level (usually 95%) over a specific time period.

For FCM’s portfolio, the one-day VaR at 95% confidence was $9.75 million on a $316 million portfolio. That translates to about 3.1 percent. The Conditional VaR (CVaR), which looks at what happens beyond the VaR threshold, was $13.96 million or 4.4 percent.

But here’s the problem. Travers compares VaR to a car airbag that does not inflate in a crash. It gives you comfort while driving but fails when you actually need it. His main issues with VaR:

• It says nothing about extreme tail events
• It assumes returns follow a normal distribution (they don’t)
• It relies on historical correlations that break down in crises
• It misses nonsystematic risks like fraud or operational failures

Despite these flaws, VaR is still worth calculating. Just do not rely on it as your only risk measure.

One interesting finding from the VaR analysis: the smallest positions in FCM’s portfolio (Krispy Kreme, Diodes, Primoris) were among the riskiest by VaR percentage. And the energy sector, despite being a small part of the portfolio, had the highest VaR of any sector. So risk was not simply proportional to position size.

Stress Tests: What Happens When Everything Goes Wrong

This is where things get practical. Travers takes FCM’s actual portfolio and runs it through historical crisis scenarios.

September 11 Stress Test: If the 9/11 market crash happened again with FCM’s current portfolio, the estimated loss would be $29 million, or about 9.5 percent in a single day. Seven of 22 stocks would have taken double-digit losses. None would have gained, though Fresh Del Monte would have been nearly flat at -0.6 percent.

2008 Meltdown Scenario: The levered portfolio would have dropped 38 percent versus 33.8 percent for the Russell 2000. Without leverage, it would have been roughly in line with the index at -33 percent.

2009 Meltup Scenario: The levered portfolio would have gained 75.2 percent versus 49.1 percent for the Russell 2000. Three stocks (Krispy Kreme, Thor Industries, GSI Group) would have each more than doubled, contributing about a third of the total return.

The up/down ratio for the portfolio was 1.98x versus 1.45x for the Russell 2000. So in these scenarios, the fund captured more upside than downside relative to the benchmark. Not bad.

The Liquidity Stress Test

Here is a finding that should make any investor nervous. Under normal conditions, FCM could liquidate its $275 million portfolio in about 13 days. But during the 2008 meltdown scenario, that number jumped to 50 days, a 257 percent increase. At their maximum capacity of $500 million, it would take 91 days.

Some individual positions were extreme outliers. Primoris would take 470 days to liquidate. Hi Tech Pharmaceutical, 265 days. That is over a year for a single position.

The saving grace is that FCM’s investor terms include lockup periods and quarterly redemptions, so they would likely have enough time. But it shows why you need to stress test liquidity, not just returns.

Factor Decomposition: Finding Hidden Exposures

Factor decomposition is a technique where you break down portfolio risk into components, like market risk, style factors (value, growth, momentum), size, industry, and others.

For FCM’s portfolio, the analysis showed:

• 94 percent of portfolio risk could be explained by the factors
• 77 percent of factor risk came from market exposure (not surprising for a levered long portfolio)
• 15 percent came from style factors
• Only 1 percent from specific industry factors

Within style factors, size was the biggest contributor at 10.7 percent, followed by earnings (3.9%) and profitability (2%). This makes sense since FCM invests in small-cap stocks.

This type of analysis helps you find risks that are not obvious from just looking at sector weights or position sizes. A fund manager might say they are diversified across industries, but factor analysis could reveal they are actually making one big bet on small-cap momentum stocks.

Interviewing the Risk Manager: Red Flags and Reassurances

The chapter wraps up with Travers interviewing Bill Hobson, FCM’s COO who also serves as the risk manager. This section is gold because it shows what to ask and what to watch for.

Travers provides a comprehensive list of interview questions, covering everything from formal risk policies to system access to VaR methodology. But the actual interview reveals some interesting dynamics.

The good news:

• FCM uses a top-tier portfolio management system
• The prime broker provides independent daily risk reports
• Trades are reconciled daily by a separate person (Aaron) and approved by the CFO
• Bill compares internal reports against prime broker reports to catch errors or fraud
• All key employees have their own money invested in the fund

The concerns:

• Bill has no formal risk management training
• The risk management system is not independent from trading, it is all in the same system
• Bill cannot personally de-risk the portfolio if he finds a violation. He has to tell Ted (the PM), who then instructs the trader
• No formal limits on sector concentration
• They do not find VaR analysis “particularly helpful” and do not actively use stress testing
• The board member with risk expertise has never conducted an independent risk assessment

Here’s the thing, some of these are not uncommon at smaller hedge funds. Bill’s explanation is reasonable: they are a small team, everyone sits a few feet apart, and any risk discussion happens in real time. The portfolio manager is not a “greedy investor” and proactively takes profits.

But Travers clearly flags the lack of independence as a concern. Industry best practice says the risk manager should be able to cut risk without asking the portfolio manager for permission. At FCM, that is not the case.

My Take

This chapter does a great job of showing that risk is not just about numbers. The VaR calculations and stress tests are useful, but the interview with the risk manager reveals things no quantitative model can capture.

The liquidity stress test is probably the most valuable analysis in the chapter. Seeing liquidation time jump from 13 days to 50 days in a crisis should keep any investor up at night. And position-level outliers like 470 days to liquidate? That is a real problem.

I also appreciate that Travers is honest about VaR’s limitations. Too many people in finance treat VaR as gospel. The airbag analogy is perfect, it works great until the moment you really need it.

The big lesson from this chapter: risk management is about people and processes, not just math. You can have all the fancy models you want, but if the risk manager cannot actually override the portfolio manager, what is the point?

Previous: Chapter 9: Operational Due Diligence (Part 2) Next: Chapter 11: Reference and Background Checks