Hedge Fund Investments: Risk Management Perspectives

Financial Systems and Bank Examination Department
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Financial Systems and Bank Examination Department: Bank of Japan

No 2007-12-26, Bank of Japan Research Papers from Bank of Japan

Abstract: Hedge funds in Japan have recently been attracting more capital from institutional investors, including financial institutions. This paper highlights the relevant risk management issues for hedge fund investments. An investor investing in hedge funds requires a different risk management procedure from the investor investing in traditional securities. This is because the investor is actually investing in the hedge fund managers' investment skills and needs to monitor multiple entities involved in the hedge fund's business operations. As a result, investors have improved their risk management, but this is still an ongoing process. This paper describes the structure of a risk management procedure for investing in hedge funds. It does so by providing examples of key elements that have emerged through discussions held with various market participants, including financial institutions, by the Bank of Japan's Financial Systems and Bank Examination Department. For an investor, the cost required to construct a proper risk management framework depends on factors such as the size of their investment. Nonetheless, investors need a risk management framework that enables the sufficient evaluation of all possible risks before beginning the investment, and the proper monitoring of these risks on an ongoing basis. This is the risk management principle for investing in hedge funds. In order for risk management to be effective, investors need to request hedge funds to provide them with enough qualitative (e.g. management policies) and quantitative (e.g. performance) information. It is important for an investor to follow this principle, and to first develop a proper risk management framework commensurate with the size and risk profile of their investment.

Date: 2007-12-26
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