Measuring Hedge Fund Operational Risk
What is the Chi Score?
Chi score is an operational risk score that developed using mathematical Benford’s law with hedge fund performance data. The Chi Score could effectively sort out high quality hedge fund from the low-quality ones in terms of operational risks. Therefore, it helps investors to select better hedge funds to invest.
How is Chi Score Calculated?
The Pearson chi-squared test is calculated. The test statistic is based on the comparison between observed and expected cell frequencies, where pi is the observed frequency and πi is the expected frequency of the first digit i. n represents the number of total counts in the data. Asymptotically, the test statistic χ2 follows a chi-squared distribution with eight degrees of freedom. For each hedge fund, a rolling window of 24 months of performance data is computed for a time series of chi-squared statistic throughout the fund’s history, in order to capture the dynamic trading behaviors of that fund. Then the average of this time series of chi-squared statistic is computed and designate it as the Chi-score for this particular fund. Each fund’s Chi-score represents the degree of that particular hedge fund return conformity to Benford’s law. The lower the score, the more the fund’s return data conforms to Benford’s law.
How can Omega Score be Used to Better Select Hedge Funds?
When you want to select hedge fund to invest, you want to invest the hedge fund with high returns. But many fraudulent hedge funds are with high returns (i.e., for example Bernie Madoff’s hedge fund). How could you differentiate the fraudulent hedge fund from high quality hedge fund so you won’t be a victim of hedge fund scandal? By using the Chi-Scores and Omega Scores. Chi-Score and Omega Score will serve you as your first and second defense to avoid fraudulent and high operational risk hedge funds. Becoming B & E Enterprise clients, you will receive a monthly file with the hedge funds with their Chi-Score and Omega Score calculated, for all the hedge fund reporting their data to TASS, one of the largest hedge fund databases. By choosing the low Chi-score and low Omega-Score hedge funds, you have effectively filter out the low-quality hedge funds. You may still want to use other criteria to further your selection and conduct due diligence report for the fund that you choose to invest in. But by using Chi-Score and Omega-Score, you have effectively avoided the high operational risk funds that you cannot detect without operational risk scores.