Red flags for hedge funds

While the hedge fund industry is maturing, the risk management and valuation practices of many hedge funds can best be characterized as in their adolescence, according to a new global study by Deloitte Research.

The report also cautions hedge fund managers and investors to watch out for nine red flags in funds’ risk management practices.

‘As hedge funds grow in size and complexity, risk management and valuation practices are becoming increasingly important for hedge fund advisers, investors, and regulators,’ said Glen Wigney, director, of the alternative investments group in Deloitte Cayman.

The nine areas identified as red flags include: lack of position limits; tracking liquidity without stress testing and correlation testing; measuring off-balance sheet leverage without stress testing and correlation testing; lack of industry concentration limits for non-sector funds; not tracking liquidity; use of Value at Risk without back-testing; using leverage without tracking on-balance sheet leverage; use of VaR, or other models, without stress testing and correlation testing; and holding assets with embedded leverage without measuring off balance sheet leverage.

‘Hedge fund advisers that raise one or more of these nine red flags need to determine whether their risk management policies and procedures are appropriate for the risks they are taking and then take the necessary steps to improve their risk management structure,’ Stu Sybersma, partner, Deloitte Cayman. ‘Investors need to watch out for these as well.’

The report – Precautions That Pay Off: Risk Management and Valuation Practices in the Hedge Fund Industry – is based on a survey of the valuation and risk management practices of 60 hedge fund advisers from across the globe. Conducted during 2006 (with assistance from Hedge Fund Research, Inc.), the assets under management of those surveyed total more than $75 billion.

The report also finds that many leading valuation practices have been widely adopted by the hedge fund industry, to the point of becoming standard industry practice, albeit not universal.

For example, while 78 per cent of survey respondents reported using a third party administrator or other third party to provide their official net asset valuation, only 47 per cent reported that they engaged a third party to provide independent pricing validation.

According to the report, the latter finding particularly suggests that investors need to carefully review valuation practices before investing – and continue to monitor hedge funds’ practices once an investment has been made.

‘The competitive landscape of the hedge fund industry is changing,’ said Barry Kolatch, a director in Deloitte Research, who focuses on the financial services industry. ‘Competition is becoming more intense, institutional investors are growing in importance, and regulators are paying greater attention. Those that thrive in this new competitive environment will be those who pay particular attention to risk management and valuation. They will be the ones who attract institutional fund investors, and, just as importantly, understand the risks they are taking and make the informed risk-return trade-offs necessary for success.’

Other highlights of the report include:

• There is very little uniformity in the valuation of various complex or illiquid assets. According to the report, the lack of uniform accepted pricing methodologies reinforces the need for independent pricing validation.

• More than 30 per cent of respondents did not disclose valuation procedures to all investors.

• Only 25 per cent of respondents include a valuation committee review as part of their regular operational risk management.

• Almost nine out of 10 (88 per cent) respondents had a chief compliance officer; the same percentage also had a written compliance policy. But, despite this, only about half as many (45 per cent) conducted a compliance assessment as part of their regular operational risk management.

‘With increased competition and more sophisticated investors, risk management will become the differentiator that attracts institutional investors and ensures the continued success of individual hedge funds in a more competitive environment,’ said Mr. Wigney. ‘While we would expect there will continue to be rapid entry and exit into and out of the hedge fund industry by small firms, pressure on revenues, along with the need to invest in risk management tools may lead to consolidation within the industry. We could also see consolidation of hedge funds with other financial institutions, such as investment banks and asset managers that already have a sophisticated risk management infrastructure.’