Nine Risk Management Red Flags for Hedge Fund Managers and Investors

Date: Monday, February 12, 2007
Author: Chris Faile, Riskcenter.com

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 last month’s global study by Deloitte Research and Deloitte & Touche USA LLP’s Investment Management Industry Group. The report 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 Garry Moody, global managing partner of Deloitte Touche Tohmatsu's investment management industry group, as well as the U.S. practice leader. “This is an age where alpha will be harder to generate and where risk management and valuation practices will be of greater importance. Some hedge fund advisers appear to be following practices appropriate for their strategies and investments. Others may be falling short.”

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 nonsector funds; not tracking liquidity; use of Value at Risk (VaR) 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,” said Glen Wigney, a director in Deloitte & Touche (Cayman Islands), who focuses on the hedge fund industry. “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 this past summer (with assistance from Hedge Fund Research, Inc.), the assets under management of those surveyed total more than $75 billion.

The report finds that a number of leading valuation practices have been widely adopted by the hedge fund industry, to the point of becoming “standard” industry practice, albeit not universal. Although 78 percent of survey respondents reported using a third party administrator or other third party to provide their official net asset valuation, for example, only 47 percent 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 (part of Deloitte Services LP), 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 important, understand the risks they are taking and make the informed risk-return tradeoffs 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 percent of respondents did not disclose valuation procedures to all investors.
  • Only 25 percent of respondents include a valuation committee review as part of their regular operational risk management.
  • Almost nine out of 10 (88 percent) respondents had a chief compliance officer; the same percentage also had a written compliance policy. Despite this, only about half as many (45 percent) 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 Moody. “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.”