A Director should know the risk and return characteristics of their Fund’s investment style and the style’s advantages and disadvantages. Significant or unique aspects of the Fund’s style pertaining to structure, market focus, and process should also be well known to the Director. For example, in regard to Hedge Funds this would include use of an absolute return goal, Fund AUM capacity, concentrations, use of derivatives and their counterparty risk, use of unquoted or illiquid investments including private placement securities, distressed investing, use of leverage, algorithms, black box factor models using complex regression equations, market timing, stub trading, implied volatility, nonlinear returns, and shorting. Also essential to know are the alpha/beta focus and its transparency, transparency of investment processes, and manager skill and consistency or the lack thereof as measured by for example the Fund’s tracking error and its information ratio versus peers. Unique risks include short volatility risks (either from short positions in call or put options or from strategies that resemble short puts including merger arbitrage, distressed debt, and event-driven Hedge Fund strategies), event risk (posing large downside risk exposure), off-balance-sheet risk (the true meaning of short volatility risk, as revealed by negative events), liquidity risk, process (idiosyncratic) risk, mapping risk, transparency risk, manager risk particularly if it is a multi-strategy Hedge Fund, vulnerability to shocks emanating from the same or other Hedge Fund strategies, association with portable alpha strategies if it is a Hedge Fund of Funds, and style drift. It is important to know whether a Fund is diversified by assets or geographically and not invested in just one asset class or one geographical region, whether the Fund is relatively old and successful, has a large AUM, receives large capital inflows, has a low redemption frequency, a long redemption notice period, a long lockup period, a long payout period, and a high watermark, all of which tend to be associated with a reduced probability of Fund failure. Fund incentive fees are common, but they tend to be associated with Fund failure, as does vulnerability to shocks emanating from Hedge Funds having the same investment style. Similarly, Funds that are invested in derivatives such as options, futures and swaps have an increased failure probability as those derivatives make giant losses more possible. When securities have limited pricing history (due for example to their illiquidity), it is difficult if not impossible for the trader who buys them to know the generic volatility risk of those securities, which is something that Directors should monitor, always asking about the downside risks of illiquid securities. Many Hedge Fund managers make use of risk budgeting. Directors should study Hedge Fund collapses. The operational risks of Hedge Funds requires the performance of operational due diligence.
Further, Directors must know and understand the strategies and tools used by their investment managers, and the strengths and weaknesses involved. Equity long/short funds take long and short positions in common stocks. Quantitative equity long/short strategies use complex multifactor statistical models to screen thousands of securities based on specific criteria, often referred to as “black-box” trading strategies that are often undisclosed to investors. Short-selling managers tend to rely on some degree of market timing. The activist investing strategy involves holding a few concentrated stock positions and emphasizes corporate governance with an involvement in company operations. Emerging market strategies have less liquidity and large downside risk. There are three primary strategies for distressed debt arbitrage: shorting a firm’s stock, engaging in capital structure arbitrage, and participation in the bankruptcy process of the target firms. Merger arbitrage strategies involve purchasing the stock of a firm that is the target of a takeover, and selling the stock of the acquiring firm in an attempt to capture the difference between the post-merger and pre-merger prices of the companies. Event-driven strategies exploit profit opportunities related to corporate restructuring events such as mergers and acquisitions, bankruptcies, reorganizations, spin-offs, stock repurchases, and other capital market events. Regulation D strategies purchase securities issued in the US under Regulation D of the 1933 Securities Act, which allows public companies to issue private securities subject to two restrictions. Fixed-income arbitrage strategies combine the purchase of one fixed-income security with the simultaneous sale of a similar fixed-income security in the expectation that their prices will converge; because the pricing discrepancies are small, the manager typically uses significant leverage to generate meaningful returns, which increases the risk of the strategy. The strategy is also applied to mortgage-backed securities. Convertible bond arbitrage strategies involve the purchase of a company’s convertible bonds with the simultaneous short sale of the company’s common stock. The risks involved include liquidity risk, interest rate risk, model risk, credit risk, call risk, event risk and leverage.
Market neutral strategies match long and short positions in related securities to eliminate market risk, making individual security selection the sole determinant of return, with remaining risk exposure being security-specific risk. Market neutral managers use factor models that are complex regression equations to relate security returns to one or more specific factors. However, market neutral Funds have very little event risk exposure. Relative value arbitrage strategies, an “arbitrage smorgasbord”, attempt to take advantage of relative pricing discrepancies between two securities while neutralizing market exposure. They include stub-trading and also volatility arbitrage, which makes use of option pricing models in an attempt to capitalize on differences in the implied volatility that exists between option prices on a particular stock. Relative value Funds follow a variety of “short volatility” strategies. Most black box processes (quantitative computer algorithms) are used with relative value strategies such as fixed income or volatility arbitrage. Relative value strategies that focus on yield spreads are exposed to credit risk since if one of the securities defaults or experiences some other credit-related event the strategy will fail completely.
Credit risky investments (such as high-yield bonds, leveraged bank loans including collateralized loan obligations, distressed (impaired) debt and emerging market bonds) are subject to negative events and have a higher probability of lower returns than predicted by a normal distribution of returns; there tends to be a collection of returns in the lower tail of their return distribution, making the lower tail fatter (thicker) than the lower tail of a normal return distribution.
Structured products such as credit derivatives include credit linked notes, total return swaps, and credit default swaps. The risks include operational risk, counterparty risk, liquidity risk and pricing/model risk. Collateralized Debt Obligations are securities that are backed by a pool of bonds, loans, or other debt instruments. They are popular with banks and insurance companies as a means to manage assets on their balance sheets.
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