1. ¹Professor of Finance at Edhec, where he heads the EDHEC Risk and Asset Management Research Center, and Director of Research and Development, Misys Asset Management Systems
2. ²University of Southern California, Marshall School of Business, Finance and Business Economics, 701 Exposition Blvd., Suite 701, Los Angeles, CA, 90089-1427, USA, Tel: +1 (213) 740 5796; Fax: +1 (213) 740 6650; Email: martelli@usc.edu
3. ³Research Engineer at EDHEC Risk and Asset Management Research Center

Revised 3 February 2003.

Abstract

As a result of the complex trading strategies they implement, and the full flexibility they have with respect to their ability to use derivatives and trade in illiquid markets, hedge fund managers, even those following zero-beta non-directional strategies, are exposed to a variety of risk factors (volatility risk, liquidity risk, credit risk, etc) in a potentially complex manner. This paper argues that a proper understanding of hedge fund risk extends much beyond a straightforward measure of linear exposure to market risk, and provides a detailed analysis of how modern portfolio theory allows the presence of these rewarded sources of risk to be accounted for when assessing the performance of hedge fund managers. The contrasted exposures of hedge fund managers to a large number of risk factors poses serious challenges to the investor, as it requires the use of appropriate techniques dedicated to their measure and control. In contrast, it is argued that this is also the driving force behind the diversification benefits investors enjoy when investing in hedge funds. The main message can be summarised as follows: the benefits and risks or alternative investment strategies are two facets of the same coin.