Confronting risk post-2008

Buy-Side Features
15 Dec, 2010

Risk is a word that comes up a lot but how are hedge funds dealing with it since the financial crisis unfolded? Charles Gubert speaks to John Metzner, COO of New York-based hedge fund Plural Investments about overcoming risk.

Mass redemptions, numerous liquidations, exposures to defaulting or severely struggling counterparties , furious and ultra cautious investors of all types, dramatic declines in assets under management, public and government backlash – putting it politely, late 2008 and early 2009 was not an ideal time to launch a hedge fund.

In this tumultuous environment, maintaining investor confidence in existing funds was hard while identifying new sources of seed capital for start-ups was even harder. Recent figures from Bank of America Merrill Lynch highlight that seed capital has declined as many of these key players have exited the industry. This, in turn, has resulted in the average size of seed deals decreasing from between $75 million and $100 million in 2008 to between $25 million and $50 million now.

Despite the challenges of finding new breeds of investors, many funds did pull it off and are currently thriving. New York-based Plural Investments is one example of a hedge fund that launched in these adverse circumstances.

Plural Investments, which opened its doors to investors in January 2009 adopts a long/short strategy on US equities.

Prior to 2008, risk management and in particular counterparty risk was not all that high on the agenda for many hedge funds. However, Plural Investments did not subscribe to that attitude. The company had been actively setting up its business during 2008 prior to the crisis. Even before other fund managers had learnt the dangers of having counterparty exposure to a single prime broker, the Plural Investments’ team was seeking multiple prime brokers to spread its risks.

“We launched our business in the view of building an institutional quality platform. We spent nearly all of 2008 building out our infrastructure and our risk management systems prior to launching. We had planned right from inception to use multiple prime brokers as we were setting up with our counterparties during the fall of 2008,” says John Metzner, chief operating officer at Plural Investments.

Metzner, a former chief technology officer at Eton Park Capital Management, a New York-based multi-strategy hedge fund and a former vice president of the prime brokerage division at Morgan Stanley, highlights that the firm’s risk management credentials was something that was important right from the offset.

The importance of risk management is reinforced by the fact that many funds with counterparty exposures to Lehman Brothers still have not recovered their assets more than two years after the crisis. Administrators from PricewaterhouseCoopers are still delving through the Lehman Brothers books trying to identify which assets belong to whom. Countless investors were burnt badly by these unfortunate events and sound risk management is now a fundamental prerequisite for chief operating officers.

“Diversification of counterparty risk was a key driver for adopting multiple prime brokers. We saw in 2007 and 2008 examples where funds had their assets with a single counterparty and they were put in a very difficult position and in some cases, it cost them their business,” says Metzner.

However, counterparty risk, while extremely important, is not the only focus for many chief operating officers. Real-time risk management is something many institutional investors believe is a must-have prior to putting their money into alternative investment vehicles. Prior to 2008, many hedge funds at best adopted an end of day or next day (t+1) approach when assessing their exposures and looking at risk management to determine trading decisions. Metzner highlights other fund managers were reviewing less timely information pertaining to their portfolio risk. “Some managers would merely glance at the Value at Risk (VaR) or other reports but it would not really be incorporated into the management of the portfolio,” he adds. “Furthermore, the presence of a risk officer or team helping to analyse or provide information to the portfolio management side of the information was also a rarity”, Metzner stresses.

These lapses and complacencies are, however, a thing of the past.

“It’s no longer acceptable to have an ad hoc or month-end view of risk. It needs to be as real time as possible. Going forward, you have to show to institutional investors that you have the appropriate risk management systems in place,” adds Metzner.

Metzner feels it is important to adopt an approach whereby data is measured as accurately and quickly as possible so it can be incorporated into the active management of portfolio risk.

Many other alternative investment companies, according to Metzner, do not simultaneously manage both operational and portfolio risk. Investing in the appropriate technology to achieve these ends is, he says, a priority. “The technology utilised by our company is a combination of proprietary and off-the-shelf products.” These, he says, have been integrated to derive the information required to properly manage portfolio risk – “this was all part of the initial plan,” Metzner adds.

“It was part of our vision for the business to build a platform to actively and accurately understand portfolio risk and mitigate as much operational risk as possible. This was all designed into the platform. We spent nine months building the systems before launching. This shows how committed we were to this approach,” he acknowledges.

One other concern that was elevated post-crisis was the lack of communication between the front, middle and back office. In some circumstances, diminished communication threw up unnecessary operational risks. Again, these faults are something Plural Investments has sought to mitigate, says its chief operating officer. “We see our responsibility as being from front to back office – everyone feels they are accountable for how the business is run. Communication failures between front and back office creates operational risk and this needs to be managed. If the operations team is afraid to talk to the traders, you have a problem. If traders don’t feel accountable to the operations team, you have a problem,” he says. With the functionality of the middle office being enhanced through the elevated focus on risk management, it is essential front office traders have real-time data when conducting trades through excellent communication links with the middle and back-office.

The days of investors chasing hedge funds are over. While solid returns are still of paramount importance to investors of all persuasions, effective risk management has gained in ascendency since 2008 and 2009. Some fund managers have acknowledged this when setting up their businesses by adopting sound risk management protocols, such as spreading risk through multiple prime brokers - these policies unreservedly appease investors.

Adopting real-time risk management, quality technology solutions and stringent front-to-back office communications bolsters the company’s understanding of risk generally. This, Metzner stresses, is particularly important when the markets are volatile. “Fund managers must understand the risk of their portfolios during both volatile and calm market periods so you are not surprised by market movements. People don’t always have good understanding of what is driving changes in the book when the market changes,” he says.

Investor demands are more stringent – greater due diligence has been adopted by these individuals and this has clearly rubbed onto numerous investment managers and chief operating officers. As Metzner concludes, “we feel dollars invested in infrastructure and risk management capabilities are as important to the sustainability of our business as dollars in the fund.”

John Metzner is responsible for the technology department and co-manages the investment staff at Plural Investments with its founder Matt Grossman. Prior to joining Plural Investments, he was chief technology officer at Eton Park Capital Management, a New York-based hedge fund and a vice president of the prime brokerage division at Morgan Stanley. He has also worked for Advent Software, Financial Models Co and Market Methodology. He holds a BS in Symbolic Systems from Stanford University.