Fund of Hedge Fund Portfolio Risk:
Understanding Hedge Fund Risk Drivers from
Manager Returns
February 2008
Y unds of Hedge Funds have long been
challenged by the lack of transparency
offered by the managers in whom they invest. Many
different approaches are used in practice when
dealing with transparency, ranging from requiring
full daily transparency to allowing "opaque"
investments where the managers only supply
monthly return information. In this paper, we
discuss some of the more popular techniques that
Funds-of-Hedge-Funds (FoHFs) use to address
transparency and we present a new advanced
methodology that allows the FoHF manager to
better understand what factors drive their portfolio's
and their managers' risk and returns. Note that in
this white paper, we use the term "Fund of Hedge
Fund" because of its popularity, but the same
analysis holds for any multi-manager platform.
Asset Allocators, Pension Funds, Endowments and
Family Offices investing in hedge funds face the
same issues and this paper address them as well.
Before we begin the analysis of FoHF transparency
and risk issues, an important point is worth making
about the use and role of quantitative risk
management in a multi-hedge fund environment.
The tools and techniques that risk management
brings to bear on the investment management
process are at their best when they are used in
conjunction with the professional judgment of the
portfolio manager / risk manager to help navigate
uncertainty in tumultuous markets. No model or
technique, regardless of sophistication, should be
used as a replacement for good judgment. The
proper role of risk management for FoHFs is to help
the manager understand the portfolio's sensitivities
and drivers of risk, ultimately leading to a better
understanding of the portfolio dynamics and to
asking better questions of the underlying managers.
While some hedge fund managers are willing to
share their holdings on a daily basis, many do not
provide such detail and limit their transparency in
some way: perhaps they send a delayed snapshot
of the positions or allocations into some set of
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exposure buckets. Some provide "Top 10
longs/shorts" or some other partial view into their
investments. Others provide no details on their
investments whatsoever and offer to inform their
investors only of their performance, typically on a
monthly basis. An individual FoHF may have some
managers in each of these categories, leading to a
variety of levels of transparency ranging from full
daily position to only
We collaborated with real monthly returns. How
Fund of Hedge Funds one goes about
using real data on real collecting and
Hedge Fund returns. analyzing such
disparate pieces of
information can be quite a challenge.
While some in the Hedge Fund and FoHF
community subscribe to the notion that meaningful
quantitative risk management requires access to full
daily position level transparency that is not a
satisfactory position when such transparency is
simply not available. The clear trend in the industry
has been the use of manager returns as a basis for
performing risk analysis. This paper presents a
significant step forward in that process.
W ealing with transparency is among the first
topics a FoHF manager needs to address.
Below, we discuss a variety of methods that
deal with some level of transparency before
addressing the main topic of this white paper, a new
returns-based technique to identify meaningful
drivers of hedge fund risks. The levels we consider
below fall into 4 categories:
• Full daily position transparency
• Limited position transparency (e.g., monthly
positions, top 10 positions, lagged
positions)
• Exposure transparency (e.g., allocations to
"exposure buckets", risk factor allocations)
• No holding transparency (returns only)
Position level transparency clearly provides the best
means of monitoring the activities of the underlying
hedge fund managers and allows the FoHF
manager to use those positions in a risk
management platform for the most up-to-date and
complete modeling of the portfolio's risks including
scenarios, what-if analyses and stress tests. It is
very rare for a FoHF to have 100% compliance from
every manager with a request for transparency
unless that is an unconditional requirement of the
investment. While there are FoHF that only invest
in managers that provide complete transparency,
that is far from the norm. The challenge then
becomes how to measure the risk of a portfolio with
mixed levels of transparency.
Partial position transparency, such as "top 10 long
positions and top 10 short positions" can result in
misleading analyses if those "top 10" do not
comprise a meaningful portion of the portfolio's total
exposure. If the top 10 positions account for only
50% of the portfolio, risk analyses based solely on
the top 10 is far from adequate but certainly better
than no risk management at all. In practice, FoHF
managers typically assign proxy positions to
account for the remaining exposure not included in
the "top 10".
When a manager provides "exposure buckets", the
firm typically sends the output from some risk
management system that assigns allocations to
different risk types. The challenge here is that each
manager will typically send completely different
buckets. Even if two managers send the same
general buckets, such as a geographical
breakdown, those buckets rarely overlap well and
do not lend themselves to aggregation. For
example, one manager may send geographical
categories of "US, Europe, Asia" while another
sends "Developed and Emerging". In these
situations, a large degree of manual data
massaging is necessary in order to make use of the
information. Even still, when one manager sends
"vega risk" and another sends "credit exposure",
there is only so much one can do to aggregate and
analyze the overall portfolio.
e eturns based analyses come in a variety of
forms, one common approach is to use
factor models. The goal is to reproduce the
manager's or FoHF's historical returns using a
series of mathematical functions of "return drivers".
In general, the returns of the fund can be modeled
as:
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R portfolio = α + β1 f1 + ...+ β n f n + ε (1)
where the portfolio's returns are broken in an alpha
term, a series of betas to driving factors, and a
residual term. The factors can be individual time
series returns (for example, of an index or factor) or
a function of a time series, allowing for quite
complex structures.
This type of analysis is used in many fields - from
econometrics to engineering - and has been a
staple of the long-only investment management field
for a quite some time. The long-only industry
typically uses only one (linear) factor in its analyses
and people there tend to speak of the fund's beta
(as if there were only one possible factor). In the
alternatives industry, where absolute returns are
sought rather than returns relative to one index,
multiple factors are used.
Since hedge fund returns are known to have non-
linear relationships to major market indices and
factors, refinements of this model are needed to
make it applicable to FoHFs. However, the general
concept of decomposing a FoHF's returns into
driving factors takes the form of equation 1 above.
Several academic studies have been done, and
several commercial firms have worked on the
theoretical issue of hedge fund return analysis,
For illustrative purposes, consider a FoHF manager
invested in 6 different commodity funds. Most of
the underlying managers trade futures on natural
gas, crude and metals. There is some minimal
equity exposure.
We use an appropriate collection of commodity
specific indices as the initial set of candidate risk
factors. Since there is a strong crude and natural
gas component, we also use rolling generic futures
contracts of varying maturities. In total, we
consider 50 different return histories.
usually accessing large databases of manager
returns in order to study which techniques and
effects are important to FoHFs. We find these
studies quite useful on theoretical grounds but
materially lacking in practicality. For this reason,
our approach has been to study the academic and
commercial literature but to develop a practical and
useful tool by working with real managers of FoHFs.
Our techniques are not only theoretically sound, but
they also pass the test of usefulness among
practitioners.
The goal of our sensitivity analysis is to reproduce a
FoHF's historical (real) returns using "the best"
basket of driving factors, using both quantitative and
qualitative analyses. Once this is done, we work
closely with the FoHF manager to identify historical
periods of interest and ranges of stresses on those
drivers that are both realistic and potentially
damaging. Note that the goal is not to predict how a
FoHF will behave in future markets, but rather, to
give the FoHF portfolio manager and risk manager a
good sense of how sensitive the portfolio is to
different factors. The return replication is not meant
for predicting future returns, but as a means to
identify the main drivers of risk and return. Suppose
a particular FoHF is best modeled with quadratic
relationship to some
driving factor (say the FoHF can have state-of-the-
US Equity Market) art risk analysis even if a
such that a 1% drop
significant portion of the book
in US Equity market
results in only a 1% is invested in non-transparent
managers.
drop in the FoHF, but
a 3% drop in US
Equities translates into a 10% drop in the FoHF.
Once such a fat tail is revealed, the prudent risk
manager will identify which of the individual
underlying hedge funds, or which combination of the
hedge funds, has the largest sensitivities to large
movements in the equity markets and then works
with them to limit the overall FoHF's sensitivity to
such extreme movements.
strategies of the underlying managers. The list can
include market indices, exchange rates, interest
rates, individual securities, and so on. It can also
include proprietary risk factors that have been
transformed into a time series. Each individual
FoHF can chose to include or exclude any particular
factors. Building the basket of driving factors is an
iterative process that considers inclusion of different
combinations of factors while it keeps track of the
"best" combination.
In order to have reasonable statistical significance,
most FoHF managers use a minimum of 24 data
points (2 years' of monthly returns), but 36 data
points is generally preferred (3 years' worth). It is
practically unheard of for a FoHF to have not turned
over a single manager in a two or three year time
span - meaning that practically every FoHF has to
rely on the manager's returns prior to their
investment as part of their return history. This is
typically achieved by using a historical return series
from the manager prior to the investment period. If
the older returns are from the same fund that the
FoHF is invested in, then the analysis is on solid
The example FoHF has 29 months of return history.
Using only this information and qualitative
descriptions of the constituent managers, it is possible
to perform meaningful risk analysis.

b ur methodology is quite simple in summary,

but rigorous and complex in detail. There
are 3 main steps in our process:
1) Determine list of potential factors
2) Build basket of driving factors:
• Perform multi-pass regression between
fund's returns and individual factors
• Consider linear & non-linear terms
• Consider lagged returns
• Use Principal Component Analysis
• Ensure independence of residual terms ground. If, however, the manager does not have an
• Evaluate goodness of fit using proprietary actual track record and has to rely on pro-forma
scoring mechanism data, then significant care needs to be taken in
examining that data before including it in the
3) Cull list with qualitative input: examine analysis.
appropriateness of each factor against stated
objectives and guidelines of each manager.
We start with a list of potential risk drivers that is
determined by considering the asset classes and

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Our multi-pass approach starts by examining all
possible factors for inclusion in the basket. It then
iterates through each of the possible factors,
performing regression analyses to maximize the
resultant score using IA’s proprietary scoring
mechanism. The scoring mechanism is shared with
our clients and sometimes modified, in consultation
with them, to take into account nuances of their
portfolio. For each iteration, only the highest
scoring factor is added to the "good" basket. We
iterate over the possible factors several times until
the inclusion of any additional factors results in a
lower overall score, indicating that we have already
found the "best" fit.
a When using our multi-pass approach on the FoHF
returns we are able to obtain an excellent fit. The
algorithm selected a linear combination of aluminum,
cocoa, precious metal, natural gas future, and gas oil
future indices to achieve an overall R2 of 0.8.
on-linear behavior is a hallmark of hedge funds.
Sometimes a fund will exhibit linear behavior for
small movements but non-linear behavior for large
movements. Similarly, it may exhibit a higher
sensitivity to the positive returns of some factors
than to that factor's negative returns. IA examines
these sorts of relationships in the process of
building the basket using both quantitative analyses
and visualization tools that allow for quick
identification and confirmation of the results.
Once the "best" basket of drivers is determined from
this quantitative analysis, a critical next step is to
apply qualitative analysis to the results. Even
though a particular basket may have the best overall
score and reproduce the fund's (or the managers')
returns quite well, the basket itself may not sit well
with the FoHF manager. It may be time to cull the
list and examine alternative factors. Removing one
or more factors from consideration (and re-running
the iterative analysis) may result in a lower score,
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© 2008 Investor Analytics LLC | 300 Connell Drive Suite 5300 | Berkeley Heights, NJ 07922 | +1 908.508.8012 | info@investoranalytics.com
but the new basket may make more sense as a set
of driving factors. In other words, quantitative
results that do not pass the "sniff test" should be
scrutinized and probably removed. Spurious results
do sometimes crop up, and it is important to use
good judgment in accepting any quantitative
From the scatter plot below, we can see that the FoHF
returns clearly indicate a non-linear relationship with
crude oil. In this case, considering squares and cubes
of the crude oil index leads to a better description of
the observed fund returns.
analysis.
Again, the goal of the analysis is to provide a
meaningful assessment of the FoHF's sensitivity to
driving factors, and no one should be tempted to
rely on a quantitative method just because the
numbers turn out a particular way. However, it is
also important to note that sometimes a manager or
fund shows significant sensitivity to a surprising
factor or set of factors. In these cases, it is best to
examine the portfolio, usually in consultation with
the managers, and determine whether such
sensitivity is real or coincidental. After the
manager's risk drivers have been identified, the
analysis should be updated each month as new
returns are generated. It is important for the FoHF
manager to be aware of changes in a manger's set
of risk drivers. While this may or may not be an
indication of style drift, being aware of a material
change in the driving factors can lead to better
questions in the course of regular conversations
with the hedge fund manager.
Once the basket of risk drivers is established, the
next step is to examine the history of the factors to
identify periods of interest and ranges of typical and
atypical returns and volatilities for the indices. This
step is important because it assesses the range of
movements that have happened over the past
several years and provides guidance on which
possible combinations of market movements can
lead to serious consequences for the fund. This
 Even though we achieved a good fit in the initial run,
the FoHF manager knows that nobody is invested in
cocoa. We remove that index from our initial set and
rerun the analysis, including powers of candidate
factors. The algorithm selected a linear combination of
aluminum, precious metal, natural gas future, and gas
oil future indices. It also selected a squared crude oil
future index. Using these factors we achieve an overall
R2 of 0.85. We have now established a factor model that
is meaningful from both a quantitative and qualitative
perspective. This model will be the foundation for stress
and scenario analyses.
information is then used in deciding not only which
historical periods to replay but also which markets to
stress when constructing "nightmare" scenarios.
The basket of risk drivers is also used for the non-
transparent managers in lieu of actual positions for
all the expected standard risk analytics - Value at
Risk, Expected Shortfall, correlations, volatility
analysis, etc.
In this paper, we have shown how a FoHF can
perform meaningful risk analysis even if a significant
portion of the book is invested in non-transparent
managers. The key is to analyze the different parts
of the portfolio on equal footing: synthesizing
transparency for those managers who do not offer it
themselves. Part of this process is incorporating the
quantitative and qualitative analyses of the
individual hedge funds. By combining the analysis
offered by a methodology such as ours with the
professional judgment and experience of its
managers, a FoHFs can have state of the art risk
management practices.
In conclusion, by using the synthesized
transparency for the non-transparent managers, the
FoHFs can take advantage of all the risk
management tools normally reserved for those only
with position level transparency.

For more information about this topic or other risk related analyses for Hedge Funds and
those investing in Hedge Fund Managers, Investor Analytics can be contacted at
info@investoranalytics.com or at +1 908.508.8012. www.investoranalytics.com

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© 2008 Investor Analytics LLC | 300 Connell Drive Suite 5300 | Berkeley Heights, NJ 07922 | +1 908.508.8012 | info@investoranalytics.com