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Hedge Funds Need Better Risk Controls

With competition so fierce in the hedge fund industry, particularly for institutional money or to be selected for a fund-of-funds platform, hedge funds must pay greater attention to risk management, valuation and transparency, according to a Deloitte Research report, "Precautions That Pay Off: Risk Management and Valuation Practices in the Hedge Fund Industry."

Deloitte conducted an electronic survey among 60 hedge fund advisors, which regularly report data to Hedge Fund Research. Collectively, the 60 respondents manage 244 hedge funds in a wide array of strategies with more than $75 billion in assets under management.

"We're seeing a trend in the industry toward greater transparency and more careful attention to risk management and valuation practices," said Barry Kolatch, a director with Deloitte Research who focuses on the financial services industry.

Funds-of-funds and institutional investors are turning to hedge funds for attractive returns and portfolio diversification. "Pension funds and university endowments have become much more important to hedge funds," Kolatch said, and these boards have a fiduciary responsibility to carefully examine and perform due diligence on hedge funds.

Thus, having risk management policies is crucial, Deloitte notes. Equally important is to allow investors to review these policies. Approximately 80% of respondents had a written policy, but only 60% shared their risk management policy with investors.

Also, boards of directors and limited partners should become more involved in the decision-making process. However, the industry is lacking in this area. Forty-three percent of hedge fund boards of directors have no input into risk management policies, and 20% received no information on such policies at all, Deloitte found.

"Firms should have an independent risk management function reporting directly to senior management," the report states.

Hedge fund advisors and even limited partners have had a tendency to overlook risk management structures while seeking alpha, said Timothy Mungovan, a partner with Boston-based law firm Nixon Peabody. "However, post-hedge fund Amaranth Advisors [losing $6.4 billion in a few days after making a bad natural gas bet], superior risk management capabilities are a competitive advantage, he said.

"Any willingness to overlook risk management structures to achieve alpha is going to diminish rapidly over the next two years," Mungovan said.

Risky Business

The report identified nine red flags regarding risk management practices, including trading limits, stress testing, liquidity analysis, backtesting and an understanding of leverage.

"Hedge fund advisors that raise one or more of these flags need to examine whether their risk management is appropriate for the risks they are taking and take steps to improve risk management as needed," the report states.

"Any fund advisor should ask themselves if they are tracking these things," Kolatch said. If not, then it should be a conscience decision and not just by omission, he said, adding that not all of the issues apply to every hedge fund.

Valuation concerns are also on the minds of investors and regulators. "Valuation is critically important and may be one of the biggest issues in the coming years," Mungovan said. Valuation can be difficult and complex because many hedge funds use credit derivatives and illiquid assets, he noted.

Hedge funds have different ways of valuing their holdings, either through a broker quote, an independent third-party advisor or a mathematical model, Kolatch said. The report showed that there is no unique way of valuing hedge fund holdings. This illustrates why it is important to have a checks and balances system, and use two to three pricing methodologies, he said. Only 47% of respondents reported that they engaged a third-party to provide independent pricing validations.

Another issue hedge funds should be conscious of is leverage. Leverage can be assessed in different ways, either open leverage, such as short selling and repurchase agreements, which show up on a fund's balance sheet; or off-balance sheet leverage, such as futures, forwards and swaps and derivatives contracts, where all or part of the notional value of the contract is off-balance sheet, the report states.

Approximately 60% of respondents monitor balance sheet leverage and 50% monitor off-balance sheet leverage for both portfolio and position risk.

"These numbers seem low relative to what they should be, as most hedge funds use at least some leverage," Deloitte states.

Credit derivatives may be something that investors want to pay close attention to when researching hedge funds due to their complexity and potential risks, such as embedded leverage, Mungovan said.

These risks are not always apparent from a balance sheet, assuming that the fund even provides positional transparency. "Many investors might even not be aware that the hedge fund is invested in credit derivatives, he said.

Many hedge funds are substantial participants in the credit derivatives markets, Mungovan said. These markets have grown exponentially over the last seven years, while operational and back-office functions have struggled to keep pace. If there is a market shock, no one knows how these markets will react, he said.

Additionally, hedge funds should be aware of liquidity issues, as they are critical to hedge funds' ability to continue trading in times of stress, the report states. If there is a small rupture in the market, assets could become illiquid overnight, said Mungovan.

Going forward, investors are going to become far more particular about which hedge funds they select, Mungovan predicted. "Funds perceived to have the best risk management will succeed in winning investors' dollars, and those that don't will ultimately fall behind," he said.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.