This article was originally published in HFM Week. By Andrew Smart.

In a recent paper, ‘Hedge Funds: A new way [1]’, Willis Towers Watson (WTW) highlights the trend of underperformance of hedge funds compared to traditional asset managers over the past 20 years.

A key factor cited for this underperformance is an excessive focus on enterprise risk management (ERM), leading to a reduction in investment risk appetite.

Further in the paper, WTW also argues that “hedge funds still have a place in client portfolios” because “they can take greater investment risk, hire the brightest investment talent and should be less influenced by ERM relative to larger institutional asset managers.”

While this is certainly an interesting argument, it is KRM22’s view that rather than being a source of underperformance, ERM is a vital management tool for hedge funds if they are to meet the challenges of today’s market conditions, turn around their underperformance and re-establish their reputation for delivery above-market returns.

In simple terms, ERM is about managing uncertainty related to delivering the firm’s strategic objectives and shareholder value. It involves the firm taking a portfolio view of their risk landscape across business units, breaking down and cutting across the traditional silos of risk to provide a view of the most critical risks.

It is also about identifying natural hedges and opportunities to offset risks across the enterprise. The ultimate goal of ERM is to protect and, crucially, to create enterprise value by enabling sustainable delivery of the firm’s objectives and ensuring that the firm remains a viable entity over time.

Investment risk is about managing the uncertainty of achieving returns that meet investor expectations. Investors putting their money into hedge funds typically have an expectation of achieving above-average returns as their ability to deliver alpha is traditionally the strategic value proposition of hedge funds.

Further, investment risk appetite is about defining limits on what is an acceptable level of investment risk that the firm is willing to run.

Therefore, within the hedge fund industry, and across the rest of financial services, investment risk management is a vital component of any ERM framework, where it has been implemented to support the board and executive team in strategic decision-making and to drive business value rather than simply ticking regulatory boxes.

By the very nature of how hedge funds operate, they must take investment risk, as risk exposure translates into investment returns. Eliminating investment risk makes no sense: no risk means no returns.

The focus must be on managing risk, typically using parameters such as value at risk (VAR) pre-trade, at-trade and post-trade with alerts triggered when pre-determined thresholds are breached.

With hedge funds increasingly falling under the scope of various post-crisis regulatory mandates, such as AIFMD, EMIR and MiFID II, any adequate ERM system will help firms manage the associated risk.

Regulatory risk management capabilities are particularly relevant considering that the regulatory focus and enforcement action is constantly evolving, moving from the firm as a whole to individual accountability.

This is encapsulated in the UK’s Senior Management & Certification Regime (SMCR), with other global jurisdictions, such as the Banking Executive Accountability Regime in Australia and the Manager-in-Charge Regime in Hong Kong, following suit.

The Monetary Authority of Singapore is also currently consulting on their Individual Accountability and Conduct guidelines.

Other risks that a good ERM system would help hedge funds counter include technology and operational risk.

Cutting-edge technology has become a critical enabler for hedge funds to generate returns, but it comes with a wide range of risk – not least of all cyber.

Operational risk is probably the most wide-ranging, least defined and most often overlooked. However, it has led to the most significant hedge fund failures.

Hedge funds are effectively businesses of risk, where doubt that they can deliver on their value proposition to deliver alpha is omnipresent.

Rather than being a source of underperformance, ERM provides the integrated, holistic management framework and toolkit to enable hedge funds to meet these challenges by turning around their performance and re-establishing their reputation for delivering above-market returns.

Andrew Smart is the head of enterprise risk management at risktech specialist KRM22.

[1] Hedge Funds: A new way: https://www.willistowerswatson.com/en/insights/2019/01/hedge-funds-a-new-way

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