Big Four Firm Lists Red Flags for Hedge Fund Risk Management

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 & Touche. The report also cautions hedge fund managers and investors to watch out for nine red flags in funds’ risk management practices. The report is based on a survey of the valuation and risk management practices of 60 hedge fund advisers from across the globe.

The nine areas identified in the report as risk management red flags include lack of position limits; and tracking liquidity and measuring off-balance sheet leverage without stress testing and correlation testing. Other red flags for risk managers are the lack of industry concentration limits for non-sector funds and not tracking liquidity. Also identified as red flags are the use of value at risk without back-testing; using leverage without tracking on-balance sheet leverage; the use of VAR, or other models, without stress testing and correlation testing; and holding assets with embedded leverage without measuring off balance sheet leverage.

The report also 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, but not universal. Although 78 percent of the hedge funds reported using a third party administrator 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.