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AIMA's Roadmap to Hedge Funds November 2008

AIMA's Roadmap to Hedge Funds November 2008

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The term risk management is very broad and is applied to nearly any human affair ranging

from road safety to mountaineering. When we talk about risk management in the context of

investment management we most often mean the management of financial risk, that is, the

risk of our portfolio. However, contingency plans in the case of a fire in the office canteen are

also part of a company’s risk management. Herein we focus on risk management of financial

portfolios.

As we have elaborated before, one of the central aspects of any risk management process is

how risk is defined. It is this definition that later dictates risk assessment, risk measurement,

risk control, risk transfer and so on. The aforementioned distinction between managing tracking

risk versus managing total risk is elementary. Afurther important distinction is between risk

measurement and risk management. The two are not the same, as mentioned briefly earlier.

The fate of Long Term Capital Management (LTCM) in 1998 is often quoted as an example of

the dangers of the reliance of any risk model output in dealing with uncertainty. Note,

however, that LTCM probably employed both - the best scientists (academics) in the field of

risk measurement as well as the best craftsmen (traders) on Wall Street. The late Leon Levy,

cofounder of the Oppenheimer Funds and Odyssey Partners, puts the limitation of pure science

more boldly while discussing the failure of LTCM:

From relative to absolute returns

What exactly is risk?

1 - From Taleb (2004), p. 165.
2 - From Bernstein (1996), p. 336.

“Once again the important fact

is knowing the existence of

these nonlinearities, not trying

to model them.”

Nassim Taleb1

Risk management touches on

many aspects

“Acommon mistake that people

make when trying to design

something completely foolproof

is to underestimate the

ingenuity of complete fools.”

Douglas Adams

Risk measurement is a science.

Risk management is not.

AIMA’S ROADMAPTO HEDGE FUNDS - NOVEMBER 2008

114

What can be made of this chain of events [failure of LTCM]? First and foremost, never

have more than one Nobel laureate economist as a partner in a hedge fund. LTCM had

two. Having had one Nobel Prize winner as a limited partner over the years, I can say

that had our firm followed his advice, we too might have lost a lot of money.1

Note that there is more praise for LTCM in Levy’s The Mind of Wall Streetthan there is

criticism. For example, Levy argues that the “willingness to take personal risk stands in

refreshing contrast to all too many Wall Street players”. As did many before him, Levy isolates

hubris as the main catalyst for LTCM’s failure (and not the failure to measure “risk”). In other

words, our interpretation of the lesson for investors is this: a successful risk measurer comes

up with an “objective” correlation matrix or any other metric for “risk”. Asuccessful risk

manager, however, knows that this metric is, at best, a biased view on future relationships

and, at worst, a tool upon which slavish reliance can result in disaster.

The debate between risk management and measurement is somewhat a contrast between

science and street-smartness, i.e., the ability to “read” the market and gain insight from

observing what is going on in the market place. An extreme example of the divide between

the two is the unfolding of the Boxing Day Tsunami of 2004 off the west coast of northern

Sumatra. All the science of Western civilization did not help to foresee the earthquake or

prevent devastation and death. One interesting aspect of this tsunami was that hardly any

members, if at all, from the aboriginal tribes were killed. They were able to conclude from

the behaviour of their animals that something bad was about to strike and they moved inland

prior to the disaster. This is, arguably, a somewhat extreme example. However, it

demonstrates that some aspects of risk are not measurable with conventional means such as

statistics, extreme value theory and all that. In the recent financial tsunami it has become

apparent that it is the decision makers who are the risk managers, not the department in the

other building that measures risk.

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