Facebook Twitter Instagram
    • About
    • Subscribe
    • Contact
    • Report Library
    • Manager Login
    Facebook Twitter LinkedIn RSS
    HedgeNordic
    • Home
    • Allocator Angle
    • Report Library
    • Nordic Hedge Award
      • Nominations 2021 Nordic Hedge Award
      • Rookie of the Year
      • Jury Board
      • Historic Winners
      • Statistics
    • Nordic Hedge Index
    • Webinars & Podcasts
    HedgeNordic

    How to Quantify Downside Risk in Hedge Funds

    Eugeniu GuzunBy Eugeniu Guzun03/12/20181 Comment
    Facebook Twitter LinkedIn Email

    Stockholm (HedgeNordic) – The purpose of hedge funds, essentially, is supposed to hedge and reduce downside risk for investors. Yet, especially in the public eye, hedge funds are often seen as complex, risky and opaque. This view is supported by prominent blow-ups such as LTCM, or cases where criminal energy abstracts the case, such as Madoff, all exploited by media and Hollywood. This raises the hard-to-answer question of how to measure risk in hedge funds. Maximum drawdown, downside deviation, and standard deviation are common measures for assessing downside risk. These measures, however, cannot estimate the tail risk – the chance of losing money in a sudden state of market turbulence.

    Back to the basics, what is the risk in investing? Many would agree that risk in investing represents the chance of losing money in the future or the prospect of an undesirable outcome and yet, we have to rely on historical data to evaluate the risk of an investment, asset class or investment strategy. Risk measures should, ideally, represent forward-looking indicators, but we are terrible at predicting the future and no “prophet” indicator can foretell it. As Michael Halling, Professor at the Stockholm School of Economics, tells HedgeNordic, “If you believe strongly that history does not necessarily repeat itself, then obviously the practicality of commonly-used measures of risk is limited.” Halling, nonetheless, puts forward an approach to measure downside risk that does not rely on history repeating itself.

    Stress Testing in Hedge Funds

    If investors want to assess how bad things can get for a hedge fund when an extreme misfortune strikes, stress testing represents the most suitable forward-looking method for assessing downside risk, reckons Michael Halling. Stress testing seems uncommon to the hedge fund industry, but Halling believes the practice of modeling the impact of hypothetical adverse market scenarios on hedge fund portfolios represents a reasonable approach to move away from the backwards-looking nature of traditional risk measures.

    A broad spectrum of stress tests can be used to shock hedge fund portfolios for almost anything depending on strategy, ranging from sharp moves in equity markets, spikes in volatility, to movements in credit spreads and other scenarios. Since correlations and price behaviours are very different in low-probability and extreme market scenarios, stress testing against different scenarios can answer many questions concerning the level of risk of a hedge fund’s portfolio. Stress testing does not come without flaws, acknowledges Halling. One disadvantage relates to the question of how to identify relevant stress testing scenarios for hedge funds, especially considering the broad spectrum of strategies in the industry. “In banking, regulators define relevant stress testing scenarios,” says Halling. The unregulated nature of the hedge fund industry, however, makes stress testing a more arbitrary and subjective approach to measuring downside risk.

    Despite the flexibility of stress testing, one of the most commonly used measures of tail risk or downside risk in hedge funds is value-at-risk. Using historical correlations of risk factors, value-at-risk spills out the worst loss in value terms that can occur over a defined period for a given level of confidence. As Michael Halling explains, value-at-risk answers the following question: “Where do the lowest-return realisations for a given fund start?”

    Value-at-Risk for Hedge Funds

    Let’s use a simple hypothetical example to illustrate value-at-risk. Consider a stock trading on a stock exchange. Now assume the standard deviation in the daily returns of the security over the past five years was 1.8 percent. In a normal distribution (of returns), 2.33 times the standard deviation represents the largest possible move the security can experience in a given day 99 percent of the time. Therefore, one would expect to lose no more than 4.2 percent of the value of the security 99 percent of the time in any given day. Value-at-risk tells us with 99 percent confidence that the security’s losses would not exceed the 4.2 percent level, but that does not mean daily losses cannot exceed that level.

    Hedge funds, of course, do not hold only one single security in their portfolios, but there are advanced value-at-risk models (which account for the fact that hedge fund returns are non-normally distributed, for instance) that estimate the potential loss on a portfolio that contains various assets and securities. Past research outlines three main approaches of calculating value-at-risk: the variance-covariance approach, historical simulation and Monte Carlo simulation. Without going into much detail, all these three approaches provide a possible outcome depending on a certain confidence level over a period of time. By delivering just one number that is easy to interpret, value-at-risk represents an attractive measure of downside risk.

    Value-at-risk can be used both to measure and control risk in hedge funds. A high number of Nordic hedge funds use value-at-risk for reporting purposes, but Michael Halling underlines that some managers use value-at-risk for allocation purposes as well. Brummer & Partners, Coeli Asset Management, Adrigo Asset Management, Rhenman & Partners Asset Management, and Catella Fondförvaltning are just a few hedge fund management companies that state value-at-risk, at least, for public reporting purposes.

    Increased interest in hedge funds from institutional investors serves as one reason for the widespread usage of value-at-risk in the Nordic hedge fund industry, as this group of clients tends to have a very structured investment approach that requires managers to answer questions related to measurements of risk, risk systems and processes, among others. Despite the common usage of value-at-risk in the hedge fund industry and asset management industry in general, Michael Halling outlines several disadvantages of value-at-risk.

    Disadvantages of Value-at-Risk and Benefits of Expected Shortfall

    One shortcoming of value-at-risk is that it does not tell anything about losses beyond the value-at-risk level. “Value-at-risk has a bit of a disadvantage because this measure serves as a threshold only – value-at-risk does not reveal how bad it can get in the tail area of less profitable outcomes,” says Halling.

    Suppose a fund manager builds a portfolio that has a 99 percent chance of incurring a daily loss of less than SEK 10 million and a one percent chance to lose SEK 500 million. Although risk limits are seemingly low when using the value-at-risk approach, the manager is clearly taking high risks.

    Whereas value-at-risk is reported as an easy-to-interpret number that shows the potential loss in monetary terms with a given confidence level, the main disadvantage of this risk measure is that the losses beyond the specified confidence level have no weight. Expected shortfall, also known as conditional value-at-risk, can be used as an improvement of value-at-risk to account for this issue, says Halling. In simple words, expected shortfall is the expected value of losses beyond the confidence level. When measuring a fund’s value-at-risk at the 95 percent confidence level, for example, the expected shortfall would equal the average loss in the 5 percent of scenarios where the value-at-risk level is exceeded.

    As Michael Halling explains, expected shortfall answers the following question: “if things get really bad, how bad do we expect bad to be?” Yet another advantage of expected shortfall over value-at-risk is that the latter measure is not sub-additive, which means one can observe situations where the value-at-risk of a portfolio is larger than the sum of the value-at-risk values of the portfolio’s components. “This does not make sense. In contrast, you would expect the opposite result because of diversification effects,” says Halling. “Expected shortfall does not suffer from that problem.” Halling also observes a “shift in the asset management industry to focus more on expected shortfall instead of value-at-risk.” This shift, however, is not visible in the Nordic hedge fund industry from the outside just yet.

    Conclusion

    According to Halling, “Obviously, investors – especially institutional investors – are very worried about how a fund behaves in crisis situations,” therefore, risk measures such value-at-risk and expected shortfall (or ideally, measures stemming from stress tests) can help put hedge fund investors and managers alike at ease.

    Share. Facebook Twitter LinkedIn Email
    Previous ArticleIn Depth: Risk Management
    Next Article Handelsbanken Hedge Fund Joins the ESG Hunt
    Eugeniu Guzun

    Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018.

    Related Posts

    Follow Your Favourite Hedge Fund

    The Winners at the 2021 Nordic Hedge Award

    Nordic Hedge Fund Industry Report 2022

    View 1 Comment

    1 Comment

    1. Phillip on 04/05/2020 3:32 pm

      Thank you for writing this article. It was the most succinct, complete, and easy-to-understand discussion of VaR and CVaR that I have read. Btw, I was just in Stavanger in Jan 2020. What a beautiful country Norway is!

      Reply

    Leave A Reply Cancel Reply

    Time limit is exhausted. Please reload CAPTCHA.

    Most read today:
    • Blockification
    • Systematic Strategies Thrive in the New Inflationary Climate
    • Follow Your Favourite Hedge Fund
    • The Winners at the 2021 Nordic Hedge Award
    • A Fundamental Formula: Focus on Valuation
    • Velliv Makes Further Inroads into Fintech
    • In-Depth: Inflation Protection

    Blockification

    16/05/2022

    The Inflation Puzzle

    12/05/2022

    Systematic Strategies Thrive in the New Inflationary Climate

    12/05/2022

    Back To The Future: Are We Heading Back To The 1970s?

    09/05/2022
    Promotion:
    Video: Manager Interviews
    https://www.youtube.com/watch?v=tni7dQvQrmo

    Subscribe to our newsletter

    HedgeNordic: Your Single Access Point to the Nordic Hedge Fund Industry!

    Check your inbox now to confirm your subscription.

    Most read articles this week:
    • Follow Your Favourite Hedge Fund
    • Systematic Strategies Thrive in the New Inflationary Climate
    • Month in Review – April 2022
    • Evli’s Forest Fund Ready to Deploy Capital
    • AFII Appoints Head of Portfolio Strategy
    • Blockification
    • Recent
    • NHX
    • In Depth

    Velliv Makes Further Inroads into Fintech

    17/05/2022

    Blockification

    16/05/2022

    Month in Review – April 2022

    12/05/2022

    The Inflation Puzzle

    12/05/2022

    Month in Review – April 2022

    12/05/2022

    Follow Your Favourite Hedge Fund

    11/05/2022

    Month in Review – March 2022

    13/04/2022

    Month in Review – February 2022

    10/03/2022

    Blockification

    16/05/2022

    The Inflation Puzzle

    12/05/2022

    Systematic Strategies Thrive in the New Inflationary Climate

    12/05/2022

    Back To The Future: Are We Heading Back To The 1970s?

    09/05/2022
    Newsletter Subscription:
    Most Recent Posts:

    Velliv Makes Further Inroads into Fintech

    17/05/2022

    Blockification

    16/05/2022

    Month in Review – April 2022

    12/05/2022

    The Inflation Puzzle

    12/05/2022

    Systematic Strategies Thrive in the New Inflationary Climate

    12/05/2022
    Publisher

    Nordic Business Media AB
    Corporate No.: 556838-6170
    BOX 7285
    SE-103 89 Stockholm, Sweden

    VAT No.: SE-556838617001
    Tel.:+46 (0) 8 5333 8688
    Mob.: +46 (0) 7 06566688
    Email: info@hedgenordic.com

    STAY INFORMED

    HedgeNordic: Your Single Access Point to the Nordic Hedge Fund Industry!

    Subscribe to our newsletter:

    Check your inbox now to confirm your subscription.

    RSS Hedge Fund Job Digest
    • Associate - Fund Operations 16/05/2022
    • Fund Project Management, Officer 16/05/2022
    • Fund Senior Accountant 16/05/2022
    • Associate - Compliance Officer 16/05/2022
    • Fund Accountant 16/05/2022
    • Fund Solutions Research Analyst 16/05/2022
    • Fund Credit Officer - Vice President 16/05/2022
    • US Tax Director 16/05/2022

    Copyright © 2022 Nordic Business Media AB

    © 2022 Nordic Business Media AB
    • About
    • Cookie Policy
    • Privacy Policy

    Type above and press Enter to search. Press Esc to cancel.

    We are using cookies to give you the best experience on our website.

    HedgeNordic
    Powered by  GDPR Cookie Compliance
    Privacy Overview

    This website uses cookies so that we can provide you with the best user experience possible. Cookie information is stored in your browser and performs functions such as recognising you when you return to our website and helping our team to understand which sections of the website you find most interesting and useful.

    Strictly Necessary Cookies

    Strictly Necessary Cookie should be enabled at all times so that we can save your preferences for cookie settings.

    If you disable this cookie, we will not be able to save your preferences. This means that every time you visit this website you will need to enable or disable cookies again.