(SSRN) We investigate the determinants and effectiveness of methods that hedge funds use to manage portfolio risk. Although there is well-developed normative academic literature on how hedge fund should manage risk (for example, see Lo (2001), Jorion (2007), and Jorion (2008)), there are no broad empirical investigations of how hedge funds actually manage portfolio risk and the effectiveness of such practices. To investigate hedge fund risk management practices, we use a proprietary database of due diligence reports prepared by The Hedge Fund Due Diligence Group at Analytical Research, a hedge fund investigation firm. Institutional investors commissioned these reports to better understand fund operations and risks when evaluating potential hedge fund investments. The reports provide extensive detail on fund characteristics, internal operations, and risk management practices. This data set addresses a major impediment to the examination of risk management practices — a lack of cross-sectional data on internal organizational practices (for a discussion, see Tufano (1996)).
Specifically, the reports identify whether the fund employs formal models of portfolio risk (value at risk, stress testing, and scenario analysis), whether the fund’s risk officer is dedicated solely to risk management, whether the risk officer has trading authority, and whether the fund employs limits on the concentration of investment positions. In addition, for a subset of funds in our sample, the reports provide managers’ expectations of how their fund would perform under extreme financial events such as a short-term equity bear market. These expectations were elicited prior to 2008. We therefore compare expectations with actual fund performance during the equity bear market of September through November 2008.
We find significant heterogeneity in methods that funds use to manage portfolio risk. Namely, risk management practices are more extensive for funds that use leverage, hold positions for shorter durations, and hold more investment positions. Specifically, levered funds are more likely to use formal models of portfolio risk, funds that hold large numbers of positions are more likely to have dedicated risk officers with no trading authority, and funds that hold positions for longer durations are less likely to have position limits. Moreover, we find that the likelihood that a fund has either a dedicated head of risk management or a risk officer with no trading authority increases in the fund’s proprietary capital, implying that fund managers increase risk oversight when they have more personal wealth invested in their fund.
We posit that risk management practices improve the fund managers’ under- standing of how changes in the financial environment would affect their fund’s performance. Examining performance during the equity bear market that occurred from September through November 2008, we find that managers of funds that use value at risk and stress testing to evaluate portfolio risk appear to have more accurate expectations about how their fund would perform during a short term equity bear market. In contrast, we find no association between the accuracy of expectations and the other risk management practices.
Furthermore, if risk management practices improve managers’ understanding of risk exposures, then funds with more extensive risk management should perform better during extreme financial events. Consistent with our thesis, we find that models of portfolio risk are associated with differences in exposures to downside risk. Namely, funds that use formal models of portfolio risk did relatively better in the extreme down months of 2008 than those that do not. The magnitude of these effects are economically significant. For example, in October 2008, funds in our sample that use at least one model of portfolio risk had returns six percent higher than funds that did not use any type of model. Read the full paper.