Anyone that has been involved in hedge fund investments in the past knows that it usually requires a substantial investment, the potential returns are high and so is the risk.  In fact, risk management for hedge funds is almost a mini-industry unto itself. 

Hedge fund managers and investors are constantly aware of the risks involved, and are always looking for way to manage that risk while maximizing returns. 

What are Hedge Funds?

For anyone who is unaware, hedge funds are investments that are generally classified as ‘alternative’.  They are private investments that aren’t available to the general public, just qualified or limited investors.  Hedge funds often use money that has been borrowed in order to increase returns and require large minimum investments.  Hedge fund investors have high expectations of their managers, expecting profits regardless of what is happening in the markets. 

Common Hedge Fund Risks

Hedge fund risks are typically broken into two different categories.  Risks that are shared with other types of investments and risks that are specific to hedge funds.  Either type can cause problems and requires effective risk management.  Here are some of the risks that are shared with other types of investments:

• Credit Risk – this refers to the risk of other parties defaulting on their financial obligations.
• Liquidity Risk – this is the risk of loss that might occur from the inability to fund investment leverage.
• Market Risk – the risk of loss because of unexpected price changes and volatility in markets.
• Operational Risk – the risk of internal systems failing.  These include technology, people, and physical elements.
• Event Risk – the risk of the outcome of an extraordinary event like a military event or unexpected election outcome.

Here are some risks more specific to hedge funds.

• Managerial Risk – a lot of the decision making power rests with one or a small number of people. 
• Transparency Risk – lack of transparency and insufficient investor control. 
• Leverage Risk – this refers to financing and volatility.
• Fraud Risk – the potential for the manager to defraud investors.
• Regulatory Risk – changing up tax or regulatory requirements of the funds.

For all of these reasons and many more, risk management hedge funds is a very important piece of the puzzle.  With so much at stake, the investors assess risk, as well as the manager’s ability to play by the rules and provide effective risk management. 

This post is brought to you Mike Sutherland, a small business owner in North America. When it comes to managing risky portfolios, he recommends R2-Financial Technologies for smart and innovative financial solutions. For more information, visit http://www.r2-financial.com/