Thursday, May 7, 2009

"Bullet to the Brain" risk - Ouch

Spending some time down in Texas at a hedge fund conference was very informative. I heard from some of the largest pension funds in the state on how they look at hedge funds in their portfolios and what they think are the most important issues they will be facing in 2009. Clearly, pricing is going to get more competitive.

One issue that was described in detail was the worrisome issue of risk management. In particular, part of the discussion started to focus on Black Swan events or as one manager called it, "bullet to the brain" risk. Other would call this tail risk, if you were from with coast. The issue is how do you protect yourself from these types of events. Actually the risk management issue took two directions. There is bullet to the brain risk from a micro-level of picking the wrong manager. This is an operational and due diligence question that can be contained through the vetting of managers.

The larger issue is the macro bet from a change in the environment that occurs quickly before the portfolio can be repositioned like what happened last Fall and through the last bubble. This is the bullet to the brain risk which may be harder to manage. Managers discussed a culture of risk management, but there really is no way to protect from some of these extreme events other than to increase diversification and to engage in active management through rotating in and out of sectors.

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