June 18, 2009 / 12:54 PM / 10 years ago

Fund managers eye hedge fund stress tests

MONACO (Reuters) - Fund managers need to stress-test worst-case scenarios more rigorously before investing in hedge funds, industry participants at a hedge fund conference said on Thursday.

Many existing stress tests, used to gauge how funds will perform in extreme market conditions, failed to identify potential problems during the financial crisis, leaving investors exposed to steep losses.

“Many allocators used models that failed to take into consideration certain risk factors, simply because they had never been seen as risks before,” Mark Schindler, portfolio manager of alternative assets at Clariden Leu, told Reuters on the sidelines of the GAIM annual industry conference.

“The second half of the year was clearly a stress test, and many allocators failed,” Schindler said.

Counterparty risk for example, or the risk that a trading partner might collapse and be unable to return a client fund’s assets, was hardly ever a factor in stress test models until the collapse of Lehman Brothers last year, Schindler noted.

Schindler said the crisis, and the missed danger signals, also provided a lesson for the academic world, on which much of the funds industry relies for its risk management modeling.

The challenge is to develop a model which is dynamic enough to incorporate and give appropriate weight to new risk factors as they arise.

Investors have become more demanding and risk-management savvy following the heavy market losses sustained last year, the worst ever for funds of hedge funds, which lost on average 19 percent according to CS/Tremont data.

“Most investors now want to know, every week, how you are making money and how you could lose money,” said Eric Debonnet of HDF Finance, a Paris-based fund of funds.

Stress testing is a vital tool in providing this information, Debonnet said, since it should provide the worst case scenario for managers and investors, and identify the factors to which a portfolio is most sensitive.

Editing by David Holmes

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