A repeat of the 1997-98 Asian financial crisis and near collapse of Long Term Capital Management (LTCM) is less likely due to the increasing sophistication of risk management among hedge funds, according to new research.
Having provided returns of close to 40 per cent annually, mega-fund LTCM folded in 1998 after losing more than US$4 billion in a matter of months, coming perilously close to causing meltdown in the global financial markets. The situation was exacerbated by the general flight to liquid assets following the 1997-98 Asian financial crises, which resulted in a massive withdrawal of capital from formerly fast-growing economies of Thailand, Malaysia, Indonesia, the Philippines, South Korea and Singapore, which were previously known as the ‘Asian Tigers’.
However, according to global research from Mercer Oliver Wyman (MOW), the hedge fund industry is in a much better position to manage volatility and crises following the introduction of US and European regulatory guidance on risk management.
The finding comes as the hedge fund industry, which is worth around US$1.5 trillion, comes under increasing scrutiny given the importance of global capital flows. The US, for example, is only able to finance its ballooning current account deficit through the massive inflow of investment capital to its markets.
“The leaders in the hedge fund industry and their banks have made substantive strides in many dimensions of their risk management practices,” said Bradley Ziff, director at MOW’s finance, risk and capital markets practice. “The largest, most influential hedge funds and their creditor banks have an extremely sophisticated understanding of their risk profiles and the market and have strengthened their ability to manage through a potential crisis.”
MOW polled more than 100 risk professionals at 15 global broker dealers and 35 hedge funds. The dealers studied represent more than 90 per cent of global business banks’ transact with hedge funds.
The primary areas of progress in risk management were in market and liquidity risk management – the ability to quickly buy or sell a particular item without causing a significant movement in the price – and have increased the ability of funds to manage the impact of shocks caused by market disruptions. However, there is room for improvement. Stress testing is also becoming an increasingly commonplace practice among funds.
Pricing and valuation of illiquid securities, increasing use of electronic trading systems and standard documentation to solve problems arising from market disputes were all identified as key areas. “The results of this study should be kept in perspective,”said Ziff. “Significant achievements have occurred. But this has not happened overnight, rather through a steady and focused effort by industry participants in both the public and private sectors.”
As risk management sophistication has increased among funds, they themselves and other institutional investors are increasingly shunning companies that cannot demonstrate successful risk management strategies.
According to analysis from Ernst & Young, around two-thirds of investors will apply a penalty to a potential investment target if they consider risk management to be insufficient. More than half of those surveyed have removed their investments for the same reason.
While investors are keen to assess risk management capabilities, many admitted being unable to source reliable information on risk and are basing decisions on incomplete risk information. This echoes previous research that found that chief executive officers globally do not trust the governance and risk information they are using to make decisions.
However, the study also found more than 80 per cent of investors will pay a premium if they see evidence of good risk management.