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Gentlemen,
While reading your posts about hedge funds I am impressed the breadth of
knowledge and research provided. I myself am a consultant to 3 off shore
funds and a CTA (who isn't these days). I worked on the floor in Chicago
and upstairs for a Major European bank, I have an MBA from a french shcool.
I reside in London and was a VP quant developing quant trading and risk
models for another Major European bank. The most shocking thing about being
in these institutions is the risk control or lack therof.
The most popular quant method is JP Morgan's risk metrics and to paraphrase
Winston Churchill on Democracy it is a horrible solution, that being said it
and its variants are some of the best solutions to Risk going.
Value at Risk basically looks for stress testing and typically assumes that
the money at risk in a position is equal to or greater than the worst case
likelihood, typically 1 percent of the time. It is obvious that this 1%
occurs roughly 2.5 times a year.
The term hedge fund is all but useless. Blind trust( in the legal sense)
would more accuretly describe these funds and their mandates. Originally as
my finance professor (who heads the MBA program at Oxford ) the term hedge
(as in a bet and later a fund)was derived from English horse race courses
where bookies would lay off their risk by passing bets through a hedge to
other bookies. Currently most hege funds have a .65 correlation with
equities, this is a far cry from there intended moniker of laying off risk.
for the equities punter.
Quant risk control as it now stands is nice and nothing more. If someone
really could assess and predict adverse volatility and position moves then
they could use that information for profit. As many have found prediction
is a difficult thing. As Keynes said of the future," we will all be dead
and that is about the only certain part" macabre humor but true.
It is unfortunate that the rapid rise in sophisticated markets such as SWAPS
and FOREX has not been met with an equal understanding of the inherent risk
associated with such markets. Systemic risk, external shock or legal
risk(monetary and central bank gambling) unfortunately do not lend
themselves to such analysis readily.
The potential for greater problems is inherent and omni-present. Look out
for more problems ahead. It is important to remember that volatility is
usually a good indicator of risk. Unfortunately the tools of Omega Research
don't allow for system optimization around Sharpe and other vol measures
easily. If one looks at the correlation of fund managers Volatility and
Drawdown you will see an interesting patterm. If a fund or trader is
returning 60% per year and has a vol. of 60% you can typically expect a
future drawdown of at least 60% or the vol.
I will not use up anymore space other than to suggest: Reading what almost
happened at the MERC in Oct. 87 by Melamed. And think about what is going
to Happen with the current Y2K problem. Multi-lateral, bi-lateral and
centralized clearing mechanisms all react to extreme volatility in many
ways. There will be some very nast surprises to come. Russia, Brazil, LTCM
and Japan will be regarded fondly as halcyon days and blips on the road to
stable evolving markets.
Nick Gogerty
London
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