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Losses in money market funds could have been foreseen, according to detailed analysis of the French market by Riskdata

November 11, 2007

Losses in money market funds could have been foreseen, according to detailed analysis of the French market by Riskdata.

• Risks undertaken by some treasury funds were not in line with investors' expectations
• Neither basic risk measures nor fund ratings succeeded to identify the nature and magnitude of risk
• Risk approaches used for alternative investments detect unobvious risks in money market funds

Background:

• Unexpected losses by French treasury funds in the summer market crisis, caused by poor understanding of exposure to mortgage backed securities and credit, are a major concern for corporate treasurers and CFOs.
• August was a major crisis for treasury funds, with OPCVM sudden losses accounting for more than 50% of year-to-date performance. For funds that lost money, this type of event should only occur — according to the most commonly used risk models — once in thousands of years.
• Riskdata, the leading Paris-based provider of risk management tools for investors, hedge funds and funds of funds, has analysed the performance of 2,000 funds on the French market with total assets under management of €1.368 trillion (thus covering most of the volume of the French funds market, which is €1.6 trillion according to AMF data).
• The funds studied were grouped into categories based on their stated strategy (using the categories of the major fund rating agencies).
• Riskdata calculated performance and risk for each category for the year-to-date and for the crisis period from July 15 to August 20.
• Of the total fund universe, some €500bn were invested in treasury funds — the typical types of fund in which corporate cash is invested on a short term "riskless" basis.

Key findings:

• Of 333 treasury funds, a few suffered losses totalling €17 million during the summer crisis, although the vast majority of funds in this category remain robust and did not suffer any losses.
• Of 122 funds in the treasury dynamic category, 39% lost money in the crisis, with losses of €393m. The average loss in the crisis of the funds that lost money in this category was -1.15%. The year-to-date performance of these "losers" was 1.05%, so over half of their yearly performance was lost in the crisis. The average year-to-date performance of this category as a whole was 1.7%.
• Of the 88 funds in the treasury dynamic plus category, 50% lost money in the crisis, with losses of €119m. But the average year-to-date return of these funds of 2.1% was superior to the treasury dynamic category, proving that labelling funds in such categories gives no indication of the actual risks being taken.
• Traditional tools to guide investors to select true risk-free treasury instruments such as volatility or even Value-at-Risk gave underestimated predictions compared to actual risks. Moreover, they did not allow the differentiation of risky treasury funds from classical low risk ones. The average two week volatility of dynamic money market category running up to the crisis was 0.2% for the "losing" funds, and also 0.2% for those that did not lose. The two week Value-at-Risk (at 99% predicted loss) was -0.49% - not much different from the much safer treasury category.

  Commenting on classical risk measure tools, Ingmar Adlerberg, Riskdata's Chairman notes: "This result confirms that classic risk measures are necessary but insufficient, as they do not allow investors to see the 'colours' or types of risk in order to carry out informed investment decisions. Also, these measures are not insightful enough in extreme crisis situations."

• Riskdata analysed the ratings of funds by a major rating agency and discovered a poor relationship between the fund rating and the real market risks being taken. In some categories of funds, funds with higher ratings were actually more likely to have experienced losses.

  Adlerberg adds: "While risk assessment probably is not the only purpose of fund ratings, this is a concern, and rating agencies would benefit from developing ratings that better reflect risks."

Alternative investment risk management approaches provide a more robust and meaningful way to understand risk

With the appropriate tools, it would have been possible for investors to avoid taking unwanted risks. Riskdata studied fund performance using the data available before the crisis and found that funds displaying high credit risk would have been evident. This also applies to anticipating the magnitude of their losses. With the information available in the beginning of July, an investor could have split all treasury funds in two buckets, based on risk as predicted by Riskdata: one bucket containing significantly higher credit risk — which mirrored the funds that actually proceeded to suffer losses — and the other bucket having minimal credit risk, containing funds that resulted relatively unscathed.

About the effectiveness of Riskdata's model, Adlerberg remarks: "Riskdata's model succeeded because it was developed for a much more modern market, namely alternative investments with its highly demanding risk control requirements. Unobvious risks cannot be identified using simplistic approaches. Just as one's health cannot be determined solely by his or her body temperature, risk cannot be reduced to a single number. The crisis highlights the need for better understanding of risk "colours" and the type and real amplitude of risk undertaken by investors and treasurers."

On the need for better practices in the industry, Adlerberg concludes that, "While there will be calls for greater regulation, Riskdata calls for better risk control practices and tools. Financial market innovation will now always outrun classical regulation. Everybody in the market — corporate treasurers, investors, regulators, asset managers — would strongly benefit from the best practices and most modern risk management tools. The risk framework developed for alternative investments needs to be more broadly adopted, in terms of systems, models, process and regulation."

Notes to editors

1. How Hedge funds behaved during this period

   Hedge funds on the whole demonstrated a much better risk-return ratio than many "riskless" money market funds, with an average crisis loss of -1.24%, but a year-to-date average return of +7.35%. This is based on Riskdata analysis of publicly available data of over 6,000 hedge funds worldwide, representing approximately 93% of the entire hedge fund universe.

   Riskdata's approach has always focused on identifying specific colours and types of risk. For example, in May, research by Riskdata into the behaviour of over 1,000 hedge funds revealed that at least 30% of hedge funds trading illiquid strategies were smoothing returns. The analysis was based on Riskdata's new Bias Ratio indicator, which is incorporated into the latest version of FOFiX, the company's core risk management application for fund of funds. This new indicator can assist in detecting manipulation of the Net Asset Value (NAV) when illiquid securities are involved.

2. About Riskdata

   Headquartered in Paris with offices in New York and London, Riskdata is the leading provider of expert risk management solutions developed specifically for the global alternative investments industry. Riskdata's comprehensive solutions enable investment managers to proactively manage and control credit and market risk while mitigating systemic and model risk through an independent, efficient and objective approach. Riskdata has substantial experience with alternative markets, quantitative modelling and IT development to deliver powerful solutions for advanced risk management and modeling. The firm has more than 100 clients across North America, Europe and Asia.

“The challenge for us was to get an aggregated view of the fund risk profile while tracking the specific risk of each underlying strategy. We think Riskdata is able to address both of these issues simultaneously. Moreover, we can monitor the impact of any portfolio allocation on the fund risk profile.”

Philippe Uzan,
CDC IXIS Multi-Strategy Fund

Our View

The Systemic Crises in Hedge Funds: What Happened in August 2007 and How to Avert a Repeat

“The challenge for us was to get an aggregated view of the fund risk profile while tracking the specific risk of each underlying strategy. We think Riskdata is able to address both of these issues simultaneously. Moreover, we can monitor the impact of any portfolio allocation on the fund risk profile.”

Philippe Uzan,
CDC IXIS Multi-Strategy Fund