Download Deloitte report identifies `red flags` for hedge fund managers and

Deloitte report identifies 'red flags' for hedge fund managers and investors
Fri, 02 Feb 2007, www.hedgeweek.com
While the hedge fund industry is maturing, the risk management and valuation practices of many hedge funds can
best be characterised as in their adolescence, according to a study by Deloitte Research and Deloitte & Touche
USA's Investment Management Industry Group that warns 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,' says Garry Moody, global managing
partner of Deloitte Touche Tohmatsu's investment management industry group and the US 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 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,' says Glen Wigney, a director of 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 conducted with assistance from Hedge Fund Research of the valuation and risk
management practices of 60 hedge fund advisers worldwide with total assets under management of more than
USD75bn.
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.
The report says that the latter finding in particular suggests that investors need to review carefully valuation
practices before investing - and to continue to monitor hedge funds' practices once an investment has been
made.
'The competitive landscape of the hedge fund industry is changing,' says Barry Kolatch, a director at 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 that 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 trade-offs necessary for success.'
The report's other findings include the fact that there is very little uniformity in the valuation of various complex
or illiquid assets, and it argues that 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, while only 25
percent include a valuation committee review as part of their regular operational risk management.
Almost nine out of 10 respondents (88 percent) had a chief compliance officer, and the same percentage had
a written compliance policy. However, 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,' Moody says.
'While we expect there will continue to be rapid entry to and exit from 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.'