June 22, 2006
Domesticating the hedge fund market
They were supposed to be the type of people who love to take risks and indulge in edge-of-the-seat pursuits. Sounds cool doesn’t it? Sadly, that is no longer the reality about hedge funds. It’s something like the Wild West. It used to be a place where the bravest of the brave dared to go and succeed. In a way, hedge funds were out there in their own wild west until recently. Now, civilization has finally caught up with them, and they no longer want to take too many risks. Don’t believe me? Check out the recent study, which was conducted by consultants Mercer Oliver Wyman that shows that hedge funds have substantially improved their risk management practices in recent years to reduce threats to the financial system and investor losses from fund failure.
Sounds like they’ve let go of the fun to make consistent returns. However, they still have a long way to go and still more needs to be done to allay risk in the fast-growing and evolving industry, where funds invest across an increasing array of asset classes in trades that are often backed by leverage, or debt.
As per the Mercer study, hedge fund managers and banks that service the industry have made substantive strides in many dimensions of their risk management practices. The study also found an interesting aspect in the working method of hedge funds. According to the study, large established hedge funds make extensive use of sophisticated stress-tests and scenario planning. This is done to offset the likelihood of being forced to liquidate positions in an unplanned or untimely manner. Such an event could threaten market stability and lead to a structural collapse.
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