Even small investment firms need formidable risk tools. If the 2008 credit crisis taught us anything, it is that risk must be taken seriously. Just ask the firms that routinely ignored the warnings of their risk officers and eventually collapsed. But what is a small hedge fund to do when it doesn't need its own dedicated risk officer?
Ajna Partners, a New York City-based global long-short equity fund, is a four-person shop with a modest footprint. While other funds have billions of dollars in assets under management, Ajna Partners oversees roughly the same amount Tom Cruise makes per film. But while it may not be a behemoth hedge fund with an opulent trading floor, and it may not need its own dedicated risk officer, it faces many of the same challenges as the big boys when it comes to risk.
According to Laetitia Garriott de Cayeux -- Ajna's CEO, CIO, risk officer and portfolio manager -- when it comes to the hedge fund's investment philosophy, her highest priority "is to protect our downside, which starts for us at the position level by picking stocks that on the long side have strong support value and on the short side have limited upside risk."
Garriott de Cayeux launched the fund in the middle of 2008, mere months before the financial meltdown. And if there ever was a good time to take risk seriously, that was it. By using "intensive" research, Garriott de Cayeux explains to Advanced Trading via e-mail, her firm develops "a high degree of confidence as to what the intrinsic value of a company is within several macro scenarios -- including intrinsic support value -- and identifies catalysts for value realization."
The path "to realizing this value," however, "can often be a bumpy one," Garriott de Cayeux acknowledges. "And we care deeply about getting a good grasp of the depth of potential negative interim effects."
To help gain a grasp of those effects, when selecting a pre- and post-trade risk tool, Ajna Partners chose the Cognity solution from FinAnalytica. It "enhances our fundamental approach by providing us with advanced risk models, which we use to assess tail risks -- in particular ETL, or Expected Tail Loss, which more accurately measures the expected extreme losses at the portfolio level," says Garriott de Cayeux. The solution is used by two people inside Ajna: Garriott de Cayeux and chief operating officer Sean Connors.
Tail risk refers to the different ends of the risk spectrum. "When people speak about risk management, people are typically talking about the negative part, like managing the downside of risk, which is the left tail," explains David Merrill, CEO of FinAnalytica. "But there are two tails, such as the right side or the positive upside potential."
Garriott de Cayeux says her goal is to maximize the returns the fund generates with limited risk -- and so far, it has worked. "Our worst one-month, rolling three-month and rolling 12-month drawdowns are less than half that of the S&P 500 and dramatically better than that of the HFRI Equity Hedge Index over the same period," she reports. "Furthermore, for each unit of tail risk, Ajna has shown more than two units of tail return, while the S&P 500 and the HFRI have shown only 0.6/0.7 units of tail return for each unit of tail risk."
Even though trading volumes may be down, the sheer number of outside news events, market data messages and other factors can have a huge impact on a portfolio, FinAnalytica's Merrill notes. "People are interested in understanding: Does it reduce the downside potential of their portfolio overall? Also, what impact does it have on their upside potential? They don't want to increase their upside potential by more than they decrease their downside potential -- that's a net negative," says Merrill.
"Because our analytics lets those tails interact independently of each other," he adds, "you get more accurate insight into what is going on."
Taking the Portfolio's Pulse
Whether Ajna Partners is considering taking a new position or unwinding an existing one, the fund fully tests its strategies, Garriott de Cayeux emphasizes. "We assess the sensitivity of our portfolio to global macro risks that would be seen before and after the trade is executed," she says.
"Finally, we stress test our portfolio based on different macro and market scenarios -- not only historical events, but more importantly, internally developed hypothetical scenarios." This helps with position sizing, risk budgeting, and overall portfolio construction and re-balancing, she explains. And from a post-trade point of view, Garriott de Cayeux monitors each position in the portfolio on an ongoing basis, "In order to catch any increase in our portfolio risk early," she says.
According to Garriott de Cayeux, FinAnalytica has proven to be an effective risk management tool for the fund. "It has helped us in creating strong returns while mitigating risk. It has also allowed us to measure and track our value-add as active portfolio managers. This is not only a great feedback tool for us, it has also greatly enhanced our reporting to investors," she says.
"Beyond ETL," Garriott de Cayeux adds, "the metrics we monitor through FinAnalytica include our beta and annualized alpha to the S&P 500, MSCI World and the HFRI Equity Hedge Index, which have been about 0.3 and in the low-teens respectively against all three indices since the strategy inception in mid-2008."
Garriott de Cayeux and COO Connors also rely on FinAnalytica's factor modeling to assess their performance during historical crises. To do this, Garriott de Cayeux explains, they look back at their portfolio immediately before a specific crisis occurred and stress test that portfolio based on the characteristics of that crisis; they then compare those results to the return they actually produced during the crisis period through active portfolio management.
"One such example was the Japanese tsunami sell-off earlier this year, during which we created strong alpha by investing in two Japanese equities whose aggregate cost basis was in the low teens of the partnership's NAV," Garriott de Cayeux relates. "An earlier example was during the 2008 financial crisis during which the major contributors to our alpha were single-name shorts, in particular in the consumer/retail sector."
Dodd-Frank and the New Risk Imperative
In these days of greater oversight, especially with the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Volcker Rule, hedge funds have had to step up their risk practices. "Certainly, Dodd-Frank has highlighted risk management as a critical aspect of fund management and essentially enforces this by way of recordkeeping and other documentation requirements," notes Garriott de Cayeux.
"We have always maintained strong documentation, as we consider this good business practice, and will continue to do so," she continues. "While the risk tools we use may change over time, fundamentally, our risk management philosophy remains unchanged."
Garriott de Cayeux adds that her firm - like other hedge funds - is poised for greater regulatory oversight as the Dodd-Frank agenda progresses. "It is clear that capital markets have important network effects that create significant systemic risk that should be managed, and regulation is a critical component of accomplishing this goal," she says. "At Ajna, we have always used network analysis as part of our fundamental research."
As an example, Garriott de Cayeux says, she does not just consider a company's balance sheet as a sum of sources and uses of funds, but also as a window into the firm's counter-parties. "This is also how we look at broader macro risk," she comments. "Going forward we will see network analysis take its proper place alongside other tools investors use when they decide how to allocate their risk budgets."