Schematically, a hedge fund is composed of an investment strategy and the operation needed to implement this strategy. Both the strategy and the operation carry their own set of risks and rewards. In order to assess the “complete” risk/reward of a particular hedge fund investment, the investor needs to combine the potential rewards and risks from both sources.

Hedge Fund managers implement various investment strategies from the popular long/short equity strategy to the complex fixed income arbitrage. Each strategy allows the manager to generate returns from the exposure to rewarding risks. The manager’s skills will determine the fund success in timing the exposure to those risks and in the hedging of the other related unwanted risks.

Basel II defined Operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. In the hedge fund context, operational risks will include: counterparty risk, liquidity mismatch, financing risk (for leveraged strategies), trading errors, systems failure, external disaster, compliance failure, legal risk … We will also include in this category reputational and business/strategic risk.

The investment strategy and operation risks have also to be analyzed in combination with the risk of fraud. The risk of fraud is a product of both personality and environmental or situational variables. Motivation is what drives the act of fraud and dishonesty is not always the sole driver. An unexpected loss due to poor risk controls around the strategy or to an operational failure can induce the motivation to commit a fraud to hide the loss with the expectation to recover quickly.