P ARKER G LOBAL S TRATEGIES Risk Management For Hedge Fund Investors: Exploring the New State-of-The-Art Riskdata New York May 23, 2006 Virginia R. Parker,

PARKER GLOBAL

STRATEGIESRisk Management For Hedge Fund Investors:

Exploring the New State-of-The-Art

RiskdataNew York

May 23, 2006

Virginia R. Parker, CFA

© 2006

• Founded 1995, 15 professionals• Specialist in designing and managing customized

multi-manager hedge fund portfolios including global multi-strategy, global hedged equity, bond substitute, energy and natural resources, FX, portable alpha, green

• Advised on allocation of over $1.75 billion • Risk oversight, estimated p/l’s and risk analytics

available 24/7 with drill down capability via secured website

• Registered in the U.S. as RIA, CTA, CPO

PARKER GLOBAL STRATEGIES, LLC

PGS Overview


What is Risk?

“Risk is the link between investment of assets and the promise of return.”


What is Risk?

“Risk is the potential for loss of control and/or value. Risk may range from the benign to the malignant, from the dormant to the brewing to the exploding. Risk may be expected or it may be a surprise. Most importantly, risk is ever present.”

© 2006

Risks Involved in Hedge Funds

• Market• Liquidity• Leverage• Concentration• Hedge Ratios• Short Volatility• Style drift• Currency Hedging

Portfolio Risks


© 2006

• Counterparty• Legal• Credit• Model• Accounting• Regulatory• Clearing• Human• Fraud

Operational Risks



© 2006

Best Practices Approach to Risk Management

• Adhere to highest standards of implementation

• Independent of trading function

• Integrated across strategies

• Empowered to act

• Finger on the pulse of the market


© 2006

Investor Risk CommitteeInvestors have three primary objectives from disclosure:

• Risk Monitoring

• Risk Aggregation Across Entire Portfolio

• Strategy Drift Monitoring


© 2006

Investor Risk Committee• Full position disclosure does not always allow investors to achieve

objectives and may compromise a hedge fund

• Summary of risk, return, and position information can be sufficient

• Evaluate information on four dimensions:

– Content

– Granularity

– Frequency

– Delay

• Reporting must be coupled with initial and ongoing due diligence reviews


© 2006

Investor Risk Committee

• Reporting must be coupled with initial and ongoing due diligence reviews

• Market, credit, leverage, liquidity, and operational risk are interrelated and should be included in the discussions


© 2006

Investor Risk CommitteeContent: the quality and sufficiency of coverage of manager’s activities including information about risk, returns, and positions on an actual and stress-tested basis.

• VaR can be useful, needs to be standardized

• Aggregate measures of a fund’s exposure to different assets

• Aggregate measures of geographical exposures

• NAV and stress measures of NAV

• Cash as a percent of equity

• Correlation to an appropriate benchmark

• Greeks

• Key spread relationshipsPARKER GLOBAL STRATEGIES, LLC

© 2006

Investor Risk CommitteeGranularity: the level of detail

• Larger funds may be more impacted by providing too much information

• Large funds need to guard against predatory trading

• Top 10 positions is useful, where it does not put investors’ interests at risk

• Alternatively, disclosure by asset class and region


© 2006

Investor Risk CommitteeFrequency: how often the disclosure is made

• Monthly summary statistics

• Quarterly for less liquid strategies or slow turnover

• Performance attribution can be useful to disclose more frequently than risk attribution

• Daily p/l provided at month end for funds marked to market daily


© 2006

Investor Risk CommitteeDelay: lag between holding period and disclosure

• Summary statistics should be disclosed as soon as possible (w/in 10 days of reporting period)

• Delay may be viewed as average holding period of strategy

• Disclosure may use generic rather than specific names if strategy is still active


© 2006

We must constantly be aware of portfolio risk and operational risk:

• Choosing

• Measuring

• Monitoring

• Controlling Exposure


Control

© 2006

• Policies and Procedures

• Middle Office

• Quantitative Models

• Strict Accounting Standards

• Strong Documentation

• Savvy Managers


Successful Risk Management

Judging The Quality of A Hedge Fund’s Performance

Low

Diversified

Liquid

Conventional

Long

Independent

Strong

Small

High

Concentrated

Illiquid

Esoteric

Short

Conflicted

Weak

Large

Exposure to Market Value

Portfolio

Positions

Strategy

Optionality

Pricing

Price Discovery

Market ImpactPARKER GLOBAL STRATEGIES, LLC

© 2006

The Quantitative ToolsRisk Measurement Must Be Tailored to the Strategy

• Value at RiskContribution to Risk Incremental Risk

• Gross • Net Analysis (Beta-Adjusted) Sector Country

• Stress Testing Key Drivers Factor Analysis

• Scenario AnalysisMonte Carlo Recursive Models

• Downside DeviationMinimum Acceptable Return Maximum Acceptable Loss


© 2006 PARKER GLOBAL STRATEGIES, LLC

(2.5%)

(2.0%)

(1.5%)

(1.0%)

(0.5%)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

24-Mar

3-Apr

14-Apr

23-Apr

2-May

13-May

22-May

3-Jun

12-Jun

23-Jun

2-Jul

14-Jul

23-Jul

1-Aug

12-Aug

21-Aug

2-Sep

11-Sep

22-Sep

1-Oct

10-Oct

21-Oct

30-Oct

10-Nov

19-Nov

1-Dec

10-Dec

19-Dec

31-Dec

Daily VaR % (Downside) Daily VaR % (Upside) Daily Gross Performance (%)

Sample VaR Track*

*Based on 2 standard deviations

© 2006

Contribution to RiskPercentage Risk In Proportion to Total Risk

- US

Germany -

32

12

108

4

10

4

9

8 3Based uponeach country’scontribution tototal value at risk.


Netherlands

Italy

Canada

Australia

Switzerland

UK

France JapanVaR = additiveVaR = correlated

Analyze highly correlated regions

Net correlated VaR for Europe = 24%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

Incremental RiskPortfolio Risk With Versus Without

Man

ager

A

Man

ager

B

Man

ager

E

Man

ager

D

Man

ager

C

Total

Portf

olio

A Key

Driv

er

A Risk

Red

ucer

A Divers

ifier w

ith sm

all ris

k

A Risk

Red

ucer

It’s not allocation of equity capital;it’s allocation of VaR.



Aggregate Portfolio Sector Exposure ReportPortfolio: SAMPLE $ %Position Date: 11/05/2001 Net: 10.7 52.21NAV: 20.58 (Millions) MTD YTD Gross: 38.5 187.2

Returns: 0.1% 9.2%

Percent (%) USD EUR GBP CAD CHF TotalIndustry Sectors Lng Sht Net Lng Sht Net Lng Sht Net Lng Sht Net Lng Sht Net Lng Sht Net

ST Interest Rate Futures 83.8 -19.5 64.3 . . . . . . . . . . . . 83.8 -19.5 64.3. . . . . . . . . . . . . . . . . .

Financial 6.3 -4.8 1.5 .3 -.1 .3 .2 -.1 .1 . . . . -.1 -.1 6.9 -5.2 1.7Consumer, Non-cyclical 5.3 -4. 1.3 .2 . .2 . -.1 -.1 . . . .1 . .1 5.7 -4.2 1.5Industrial 3.6 -2.6 .9 .2 . .2 .1 -.1 . . . . .1 . .1 4. -2.7 1.3Consumer, Cyclical 3.9 -1.8 2. .1 . .1 . -.1 -.1 . . . . . . 4.1 -2. 2.1Index Futures . -5.8 -5.8 . . . . . . . . . . . . . -5.8 -5.8Communications 3.5 -1.8 1.6 .1 . .1 .1 -.1 . . . . . -.1 -.1 3.7 -2. 1.7Technology 2.6 -2.9 -.4 . . . . . . . . . . . . 2.6 -3. -.4Utilities 2.4 -.8 1.6 . . . . . . . . . . . . 2.5 -.9 1.6Basic Materials 1.6 -1.2 .4 .1 . .1 . . . . -.1 -.1 . . . 1.8 -1.4 .4Energy 1.9 -.3 1.6 .1 . .1 . . . . . . . . . 2. -.3 1.7LT Bond Future . -.5 -.5 .9 . .9 . . . .3 . .3 . . . 1.5 -.5 1.Unclassified 1.1 -.2 .9 . . . . . . . . . . . . 1.1 -.2 .9Funds . -.3 -.3 . . . . . . . . . . . . . -.3 -.3Diversified . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

Total Long & Short (%) 116. -46.7 69.3 2.1 -.2 1.9 .6 -.6 -.1 .3 -.1 .2 .3 -.2 . 119.7 -48. 71.7

NAV:(Millions) 20.6Fund Net Exp. ($1,000,%NAV) 14.3 69.3% .4 1.9% -.01 -0.1% .05 .2% .01 .% 14.8 71.7%Fund Gross Exp. ($1,000,%NAV) 33.5 162.7% .5 2.2% .24 1.2% .09 .4% .1 .5% 34.5 167.7%


Equity Long/ShortSector Exposure Report (Beta-Adjusted)

Financial

Industrial

Consumer, Non-Cyclical

Consumer, Cyclical

Communications

Basic Materials

Energy

Technology

Diversified

Utilities

Gross Net

8.9 2.1

5.7 3.1

4.8 2.2

2.5 .5

3.3 .7

1.7 .9

.1 .1

.5 -.3

.4 -.4

.4 .4

Short Long0-3.4

-1.3

-1.5

-1.0

-1.3

-.4

-.4

-.4.4

.1

.1

1.3

2.0

1.5

3.3

4.4

5.5


Riskdata Analysis: Fund of Hedge Funds


Number of constituent funds 12 + cash

95% VaR below the risk-free rate per month; annualizes at 4.8%

Marginal contribution to VaR for the

top five largest allocations

Using Riskdata on the FoF level – Estimating VaR


Estimating significant exposures on the FoF-level

Market drivers bucketed in 12 types

Only consider drivers that have a significance

metric of at least 0.4

FoF is long equity as given by ‘North American Market’; up-beta 0.25% and down-beta 0.38%

t ‘Health Care’ but since we have have position-level transparence, we know this is spurious

The ‘next significant’ sector-driver is utilities and this is confirmed by the position-level information


Estimating extreme exposures on the FoF-level

For large moves, ie 1% tail moves in the underlying market drivers, the up- and down betas differ. The only significant types of drivers are still ‘Sector’ and ‘Equity’

The betas for the large up- and down moves conform with position-level information; the main ‘Sector’ driver is identified as ‘US utilities’ by the system


Estimating the impact of historical market dislocations

‘Canned’ historical default scenarios provided by system; user can define own scenarios be assigning start- and end dates

‘Impact’ on the FoF-level estimated by applying returns of the market-drivers to the aggregated up- and down betas (‘regular’ and ‘extreme’ as appropriate) for the periods of the dislocations


Riskdata Analysis: Event Driven Hedge Fund

© 2006



Manager A - Event Driven

$0

$1,000

$2,000

$3,000

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$5,000

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$7,000

$8,000D

ec-9

6

Apr-

97

Aug-9

7

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7

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98

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8

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8

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99

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9

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9

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00

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01

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5

Apr-

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• Manager A is Event-Driven - Opportunistic according to market environment- Has included distressed, merger arb, activist

• We have position level transparency and daily returns since investing• PGS First invested in May 1998

© 2006

Sensitivity Profile – Event Driven Manager


• Most recent 36 months ending April 10, 2006

• Biggest factor exposures are sector, style, and cap size• Manager has been < 50% US for past 18 months


Extreme Sensitivity Profile – Event Driven Manager

• Highest sensitivities are equities and utilities• Currently Manager is up 10% YTD through April• Down 3.3% for May through the 19th

© 2006

Stress Events: Estimated v. Actual


-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

98 L

TC

M

98 R

ussia

n

Defa

ult

01 S

ept.

11

00 T

ech

Bubble

97 A

sia

n

Curr

encie

s

IMPACT MONTH PERIOD

CRISIS STARTING ENDING IMPACT MONTH PERIOD98 LTCM 1-Aug-98 13-Oct-98 -10.16% 0.40% 0.70%98 Russian Default 15-Jul-98 15-Sep-98 -9.36% -1.75% -2.74%01 Sept. 11 5-Sep-01 25-Sep-01 -7.37% -2.10% -2.10%00 Tech Bubble 1-Apr-00 30-Dec-00 16.32% 1.60% 6.73%97 Asian Currencies 1-Aug-97 28-Oct-97 -1.23% 0.40% 1.00%


Riskdata Analysis: Japanese Activist Fund


Japanese Activist Fund


Japanese Activist Fund

With the exception of Main Japanese equities with the strength of 0.2, the analysis does not identify any significant sensitivity to other intuitive factors.

A positive sensitivity to Beta in both directions with a spread of -0.1 (Gamma) suggests a marginally negative net market exposure. This also suggests the short book to be the main contributor of the portfolio returns.

A lack of appreciable strength to any of the major factors renders this manager un-explained by our Risk Data analysis.

© 2006

Risk Management is ActionPrudent Actions Before Investing

• Establish Watch/Cut/Termination Levels• Careful Due Diligence

– independently verify reputation – understand what can go wrong with the strategy– examine the portfolio

• Thorough Review of All Documentation– offering memorandum– investment manager contract– subscription agreements– administrator and Auditing engagement letters– audits– client communications

• Diversify, Diversify, Diversify


© 2006

Risk Management is Action

After Investing

• Terminate a manager/redeem from a fund

• Require a manager to reduce exposure

• Independently overlay an offsetting hedge

• Remember, no action is an action


Successful Hedge Fund Investing Requires:

• Diversification across strategies, managers, and factors

• Transparency to monitor style, risk, and performance measurement

• Quantitative risk measurement tools for objective, independent evaluation

• Accurate performance measurement to judge the quality of the return

• Ongoing due diligence – situations change over timePARKER GLOBAL STRATEGIES, LLC

PARKER GLOBAL

STRATEGIES

1177 Summer StreetSixth Floor

Stamford, CT 06905Phone: (203) 358-4000

Fax: (203) [email protected]

© 2005

P ARKER G LOBAL S TRATEGIES Risk Management For Hedge Fund Investors: Exploring the New State-of-The-Art Riskdata New York May 23, 2006 Virginia R. Parker,

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