How Risky Is That Hedge Fund?
Hedge funds are risky. But getting beyond that bromide and evaluating the prospects of a particular fund means understanding everything from internal operations to investors’ incentives to counterparty and market conditions. David Belmont ’92, chief risk officer of Commonfund, gives a tour of the inner workings of hedge fund risk.
There are a thousand ways for a hedge fund to die.
The fund could bet big on a rise in natural gas prices, and then watch as a mild winter and other factors keep prices down, until it runs out of time and cash.
The firm could be celebrated after a good year, then, after one down year, see its investors pull their money and walk out the door.
Fund managers could overstate earnings for years and siphon off excessive fees for their personal use, until they get caught and prosecuted, leaving investors with next to nothing.
Or a highly prominent founder and head could be arrested on insider trading charges and eventually convicted, bringing down the whole firm.
Then there’s the collapse of a counterparty. A rogue trader evading controls. A trading software failure. Or key employees could always defect and join a rival firm.
And then, of course, the fund could get swept up in a widespread market crash, as happened in 2008, when a record 1,471 hedge funds went out of business.
Possibly no one worries more about all of these risks than the investment banks that act as prime brokers for hedge funds. Prime brokers provide a suite of services to hedge funds, granting them access to capital markets and providing margin financing and matchmaking services that allow funds to execute on various investment strategies. This means that their capital is at risk if a hedge fund fails.
David Belmont ’92, currently the chief risk officer at Commonfund, was previously in charge of risk management for the prime brokerage business at UBS Investment Bank. Speaking to students as a guest lecturer in the Yale SOM course Hedge Fund Strategies, he explained that prime brokers have a limited upside in their relationships with hedge funds—interest payments and other fees they get for their services—and potentially massive downside risk, since they can lose all of the money they extend to the funds. A prime broker needs to carefully assess every aspect of a hedge fund’s operations, strategy, and personnel. “We had to take risks,” Belmont said, “but we had to do it intelligently.”
In this excerpt from the class, he describes some of the thinking and strategy outlined in his book Managing Hedge Fund Risk and Financing: Adapting to a New Era, and discusses why it’s critical to look at the perspectives of all the players, including investors, hedge fund management, and prime brokers, to get a complete picture of risk. “I view hedge funds as a prisoner’s dilemma, where as long as everybody cooperates, everybody gets something. But every individual has the ability to take down the house of cards,” Belmont said.