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ôWe are currently outsourcing risk management because having a third party adds a degree of legitimacy in theory and in fact,ö says Aaron Boesky of Marco Polo Investments in Hong Kong. ôThere can easily arise conflicts of interest internally. But we do believe in internalization depending on the sophistication and liquidity of the strategy. For highly liquid and standard long/short managers like us the need for internalization is less so.ö
Hedge funds can outsource risk management to an outside firm. One operating in Hong Kong now is Quality Risk Management & Operations (QRMO), whose founders Angus Hung and Albert Chiu met at Mizuho Securities, where they were handling a proprietary hedge fundÆs market risk. They found that the prime brokerage-supplied risk management platform with which they were supplied was lacking æoomphÆ to tackle the harder problems. For example, when they were calculating Greeks, the answers didnÆt seem to be right. They were equally ambivalent about the numbers they were receiving back from their hedge fund administrator.
So they left Mizuho and set up QRMO. Getting the first clients was a struggle, as they had no testimonials to prove to hedge funds that they could deliver the goods. Concessions and free usage was offered initially and the client list built up. Today it employs a staff of six. With five local hedge funds signed up, even the founders still have to do day-to-day spade-work for their clients in such fields as VaR reporting, stress testing and sensitivity analyses.
ôThe basic platform provided by a prime broker is usually adequate for fundÆs employing simpler strategies such as long/short, but it is in many ways non-customizable, which is a downside for fundÆs using more complex strategies,ö says Michael Langton, manager of QRMO in Hong Kong. ôAlso, will your prime brokerÆs in-house risk expert attend investor meetings to discuss the risks facing a hedge fundÆs portfolio, provide independent risk commentary, help draft up risk management policies and regular communication letters to investors?ö
On the middle office side the firm offers such jobs as, reconciliations, portfolio valuations, P&L and net asset value reporting. It has been found that their NAV calculations are within a five basis point range of that ultimately produced by the hedge fundÆs administrator each month. (A fund still has to employ a hedge fund administrator).
ThereÆs risk management and thereÆs risk monitoring. Outsourced risk management means sticking to whatever ground rules have been stabled, frequently enshrined via some sort of reporting capacity and notification of exceptions. The outsourced risk manager seldom gets to strong-arm reduction of trading positions.
However, this in many ways mimics the wider world, as even what investment banks call ærisk managementÆ is invariably just risk monitoring, as thereÆs absolutely zero chance in a Wall Street investment bank that a credit officer could take it upon himself to order and execute close out of a wildly over-limit position. In many senses, a credit officer on Wall Street is seen by insiders and incumbents as an academic position displayed to ratings agencies as de facto evidence of responsible corporate governance. As we saw with Merrill LynchÆs declaration this week of its sub prime losses - $5 billion û no - $8 billion, deciphering the risk management numbers that are marked-to-model sometimes results in farce.
Deconstructing credit risk is getting harder as accountants find new ways to conceal problems. For example some US banks are switching CDO positions from trading inventory to long term hold positions which do not require marked-to-market treatment. Look for securities moving from "available to sale" to "not available to sale." Secondly they are embracing "re-couponing schemes" û which involves re-characterizing the coupons received as "income" and "additions to revaluation reserves".
However in a hedge fund, investors doing deep due diligence will scrutinize the risk policies intensively, and in this sense investors in the alternatives sector take the entire risk issue far more seriously than do the shareholders in investment banks, making it doubly ironic that hedge funds invariably get more rap than investment banks on the subject of risk.
What does it cost to outsource? A big hedge fund would pay basis points on their NAV but a smaller one, a fund, say, with assets of $15 million; a combination of middle office and back office services might cost $4000 per month.
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