Chapter 8 - The Hedge Fund Paradigm

Abstract

Absolute return strategies from hedge funds offer diversification to a traditional portfolio of equity and bonds. Moreover, hedge fund managers manage absolute risks rather than relative risks. This is a large paradigm shift that sweeps over the entire asset management industry. However, there are recurring concerns about the risks involved in hedge funds. In the hedge funds arena, various risks focalize. Hence, hedge funds form the litmus test for a risk manager. This chapter reviews the hedge funds biotope, regulatory issues, and their fee structure. These institutional features give rise to some risks that are idiosyncratic to hedge funds. The chapter discusses the various investment styles of hedge funds and highlights the way in which factor models from the traditional asset management industry is used in the hedge fund world. It also describes the types of risks that are typical for hedge fund investing. Hedge funds expose themselves to various investment risks such as liquidity risk, credit risk, political risk, and catastrophe risks. These risks are amplified by the typical high leverage in the balance sheets of hedge funds.