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Traumatic year turns focus to the fat tail

After a traumatic year for alternative fund managers and their investors in 2008, the hedge fund industry is having to take risk measurement and management processes a great deal more seriously.

After a traumatic year for alternative fund managers and their investors in 2008, the hedge fund industry is having to take risk measurement and management processes a great deal more seriously. The past year has also provided a unique test-bed for the ability of in-house and third-party risk management solutions to perform effectively not only in a benign environment but under much more volatile and challenging market conditions.

In the past hedge fund managers have been accustomed to reporting value at risk (VaR) numbers to their investors, but for many this has been more a formula than an integral part of their investment process. Now, however, the limitations of VaR measurements have been highlighted, along with the importance of being able to assess the likelihood and potential extent of extreme market events.

These developments have spotlighted the capabilities of risk management solutions offered by SunGard. In the hedge fund space, its offerings include the Front Arena front-to-back trading system, which enables real-time cross-asset class risk analysis encompassing equity, credit, interest rates and commodities, and RiskHedge, an outsourced risk solution that is accessible and affordable to smaller hedge funds but also popular with service providers offering risk reporting to their clients.

An important advance for SunGard was the acquisition a year ago of APT, a business with a 20-year track record in buy-side risk analytics. The APT product suite includes a hosted risk reporting offering, enabling managers to monitor such metrics as tracking error, portfolio volatility or value at risk. It helps them identify which positions are contributing most to risk, and supports portfolio construction, for instance by proposing a list of trades to minimise the variance of the portfolio.

The capabilities of APT are particularly important, given that events in 2008 emphasised the quality of risk numbers much more than in the past. Last year’s turbulence exposed the failings of some risk metrics and methodologies – and demonstrated the value of APT’s emphasis on economically motivated risk models.

In a sense the value at risk model failed, because in market crises all the normal relationships from which value at risk is calculated break down. Also, by focusing on a 95 or 99 per cent confidence interval, value at risk measures the sort of loss that can happen 19 days out of 20 or 99 times out of 100. But last year we learned that what really matters is what happens in the tail, the extreme event in the really bad month or year.

Most risk measures are built on the assumption that asset returns such as share and commodity prices, and most economic factors, are normally distributed, so they always underestimate the probability and magnitude of extreme events that in fact happen much more frequently that the normal distribution would imply.

SunGard APT can calculate a ‘fat tail’ version of value at risk and analyse portfolio risk inside the tail. APT makes no assumption that asset prices or economic factors are normally distributed. Comparing APT’s risk forecasts for each quarter of 2008 with what actually happened has demonstrated that its metrics taking into account the actual probability of extreme movements, rather than any assumed distribution, performed much better than the typical value at risk forecast.

Paul Compton is head of product management with SunGard Alternative Investments

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