Hedge fund of fund investors may start using overlays

Improved risk exposure reporting by hedge funds may spark the introduction of new overlay strategies by investors increasingly concerned by bubbles of non-diversifiable risk in their portfolios.

Robert Aaron, chairman and chief executive of Derivatives Portfolio Management (DPM), a Somerset, New Jersey-based back-office administrator servicing approximately $14 billion in hedge fund assets, said growing risk transparency of hedge funds could lead investors to hedge non-diversifiable risks.Pointing to the growing popularity of hedge fund risk exposure reporting technology offered by New York-based vendors Measurisk, RiskMetrics and Investor Analytics (in which he is an investor), Aaron said specific risk exposures in a portfolio of hedge fund investments, for example to Japanese yen, could grow too fast for an investor to rebalance his hedge fund portfolio, leaving hedge overlays as the only option.

“Someone will eventually use that information to reduce risk – either by redeeming a trader or putting on a call or a put position,” Aaron said. But Aaron added that he was not yet aware of any investors using overlays at present.

DPM was spun off nine years ago from Tricon, an $800 million proprietary trading firm partially owned by Commodities Corporation, itself acquired by Goldman Sachs in 1997. Originally charged to wind down Tricon’s assets in the early 1990s, DPM now provides trade processing, reconciliation, net asset value calculation and other services for hedge funds and investors. Working with risk technology vendors, DPM has provided investors and hedge fund clients with daily online value-at-risk figures.

Aaron expects hedge fund assets to double in the next three to four years, while he predicts DPM’s business will quadruple.