Value at risk (VaR)

Value at Risk (VaR) is essentially a way to answer the question: "What's the worst loss we might expect on our portfolio over the next day, week, or month?" For example, a fund might calculate that there is only a 5% chance it will lose more than $10 million over the next month under normal market conditions. That $10 million figure would be the fund's monthly VaR at a 95% confidence level.

Institutional investors—such as , , and insurance companies—regularly ask hedge funds to provide VaR calculations and other risk measures. These investors want to understand how much risk they are taking when they invest in a particular fund. VaR serves as one tool among many that helps investors assess a fund's potential downside and compare risk levels across different investment options.

When institutional investors decide to invest in a hedge fund, they often negotiate for access to detailed portfolio information through special agreements called . These agreements give certain investors the right to receive information that is not provided to all investors in the fund.

Through these side letters, investors may request various types of data about the fund's holdings and risk profile. Common requests include the fund's largest positions, how much the fund uses, whether the fund is betting on rising or falling prices (net long or short positioning), and how concentrated the fund's investments are in particular geographic regions or industry sectors. VaR calculations are frequently part of these information requests, along with other quantitative risk measurements.

Some investors go even further and negotiate for complete portfolio transparency, meaning they can see exactly what the fund owns at any given time. Institutional investors seek this information because their own internal risk management systems require them to monitor and understand all their investments. Additionally, this data helps them ensure they are properly diversified across their entire investment portfolio.

VaR becomes especially important for hedge funds that use significant amounts of leverage or employ complex investment strategies. Consider statistical arbitrage strategies, for example. These strategies involve using computer models and quantitative analysis to identify small pricing differences between related securities—perhaps hundreds or thousands of different stocks or bonds.

Funds using statistical arbitrage typically execute large volumes of trades systematically, buying and selling securities based on their proprietary models' predictions about price movements. Because these strategies often involve holding many different positions simultaneously and may use leverage to amplify returns, calculating VaR helps fund managers understand the potential downside risk from all these coordinated trading activities.

The VaR calculation provides a single number that summarizes the portfolio's overall risk exposure, making it easier for both fund managers and investors to assess whether the potential losses are acceptable given the fund's investment objectives.

VaR measurements prove particularly valuable for , which invest across several different approaches simultaneously, and for , which invest in multiple underlying hedge funds rather than directly in securities.

Multi-strategy funds might combine long-short equity strategies with fixed-income arbitrage, , and macro trading all within a single fund. Each of these strategies carries different types of risks, and VaR helps portfolio managers understand the combined risk exposure across all strategies.

Fund of funds managers face a similar challenge but at a different level. They must evaluate and monitor risk across their portfolio of underlying hedge fund investments. These managers often negotiate for access to detailed transparency and reporting information from each underlying fund, including VaR calculations. This data helps them understand their total portfolio exposure and assess whether their various fund investments are truly diversified or whether they might be unknowingly concentrated in similar risks across multiple underlying managers.

When hedge funds provide VaR measurements and other detailed portfolio information to select investors through side letters, they create an . Some investors have access to non-public information about the fund's holdings and risk profile, while others do not.

This situation requires careful management because investors with access to detailed portfolio data could potentially use that information in ways that harm other investors in the fund. For instance, an investor who sees concerning VaR trends or levels might decide to redeem their investment before problems become apparent to other investors, leaving those other investors to bear the losses.

To address these concerns, hedge fund sponsors typically require investors receiving enhanced information access to sign written . These agreements legally bind the investors to keep the information private and restrict how they can use it. Fund managers must balance their desire to attract institutional capital—which often requires providing detailed transparency—with their obligation to treat all investors fairly.