A Best Practice Protocol for the Risk Measurement of a Portfolio of Hedge Funds

Abstract

The authors review, refine, and attempt to formalize the emerging best-practice approach for the measurement of the market risk of a multi-asset-class, multi-strategy, fund of hedge funds portfolio. The approach involves a good level of transparency from the manager and the active participation of an independent fund administrator, an independent risk aggregator, the investor, and the manager. The approach is increasingly being adopted in the industry but there are challenges, such as obtaining timely, granular, and verified transparency from managers. Although the discussions in this article are in the context of traditional hedge funds (i.e., those that invest in publicly listed securities), the authors suggest steps that could be taken so as to expand the protocol to include more nontraditional hedge funds, such as those that invest in illiquid assets and carry idiosyncratic risks. Many of the elements outlined in this article are already well known in the industry but are underutilized, perhaps as a result of a lack of awareness or understanding between manager and investor.