367CHAPTER 25 SOURCES OF CHANGE AND RISK FOR HEDGE FUNDS Clifford S. AsnessA lot of change is on the horizon for hedge funds, particularly given institutional investors growing use of alternative investments. The changes will likely bring a greater focus on benchmarking, calls for increased transparency, a need for better articulation of investment strategies, rationalization of hedge fund fees, and the need for solid risk control mechanisms. The future also brings subtle shifts in hedge fund risk. And although the risk of blowups still exists, perhaps the larger future risk will relate to diminished returns. In this presentation, I will take a big picture view of the hedge fund world, but the core of the presentation will relate to an idea that is coming up ever more frequently hedge funds are becoming much more institutionalized. Although institutionalization can mean many dif-ferent things, I will jump right in and describe it through a focus on five key issues that come up as a consequence of institutionalization: benchmarking, transparency, articulation of the investment strategy, fee rationalization, and risk control. BENCHMARKING For better or worse, institutionalization brings about a greater focus on benchmarking. And a myriad of ways exist to set up a benchmark depending on whether the investor wants to Reprinted from CFA Institute Conference Proceedings: Challenges and Innovation in Hedge Fund Management (August 2004):4 9, 13 14. Note: Clifford Asness was joined by Dan Och in a joint Question and Answer Session at the end of his presentation. CH025.indd 367CH025.indd 3678/28/10 8:36:53 PM8/28/10 8:36:53 PM368 Part III: Managing RiskAlternative Investmentsanalyze an individual hedge fund manager or a hedge fund program. Probably one of the most basic benchmarks is a simple absolute number, which could be any number that the manager and client agree on. Of course, an absolute number makes little sense in a world where inflation and interest rates move around. Because getting around that problem is difficult, another level of bench-marking adjusts for changes in inflation and interest rates. At this level, investors will typically see an absolute number that is some proxy for a risk premium plus a measure for rates, such as 6 percent plus T - bills or the U.S. Consumer Price Index (CPI). But if investors are going to recognize an external influence, such as rates, why not go a step further and recognize that many hedge fund strategies have at least some exposure to market performance? Even if the correlation of hedge funds with the market is supposed to be low, bad years for the market are tougher - than - normal years for hedge funds. Moreover, some explicit market beta is built into certain strategies, such as long short equity. In recognition of that exposure, the third level of benchmarking includes adding an element of market performance to the equation (e.g., CPI ? 3 percent ? S the skill and market knowledge necessary to implement many hedge funds strategies are considerably greater than the skill and market knowledge needed to replicate a stock index. RISK CONTROL Having a concern about risk control is certainly not unique to institutions. But it is an area where institutions are more apt to focus. Generally, I believe that the second worst thing a hedge fund manager can do is to operate without a solid system for risk control. The worst thing a manager can do is to lose his or her cynicism about the risk management system that is in place. Building a good risk system is probably one of the areas where I have spent the most time in my professional life. As one can imagine, trying to measure risk within a hedge fund can become quite complicated considering all the different variances, co variances, frequen- cies, and weights within a portfolio. On top of all that work, we at AQR believe strongly in a human element. We give ourselves one - way authority to take less risk than what our models are calling for. We do not, however, give ourselves two - way authority, which would allow us to increase risk, for instance, if we were in a good mood that morning. Three specific sources of risk beta, leverage, and headline risk are important to institutions, so I will cover these three in more detail in the following sections and then discuss current hedge fund risks. Beta A few years ago, I co - wrote a paper that, at the time, was fairly controversial. 1 Our thesis was that hedge funds not only have beta; they have more beta than people tend to predict. Our experience since the paper was published has continued to support that conclusion. CH025.indd 371CH025.indd 3718/28/10 8:36:55 PM8/28/10 8:36:55 PM372 Part III: Managing RiskAlternative InvestmentsFigure 25.1 illustrates my point. The gray line represents the rolling 12 - month return of long short equity strategies as measured by the CSF