Deloitte Risk Management
Deloitte Hedge Fund Risk Survey
Accounting firms are muscling up for market share in the growing hedge fund industry. Last week Ernst & Young were voted best (hedge fund) accounting firm by the influential Hedge Fund Journal, following the hedge fund symposium they road showed globally earlier in the year.
Now Deloitte, in conjunction with Hedge Fund Research, have issued a research study focused on Risk Management titled "Precautions that Pay Off - Risk Management and Valuation Practices in the Global Hedge Fund Industry." The study was based on 60 mostly US-based groups managing about 244 hedge funds. The survey covered a wide range of hedge fund strategies and hedge fund sizes.
Deloitte conclude that the growing hedge fund industry needs to improve its management of risk. Deloitte said many hedge fund groups - which typically follow more aggressive investment strategies - lacked best practice guidelines, such as independent asset valuation or external administrators.
Deloitte raise the concern that the rapid growth of hedge funds (20% pa over the period from 1995 to 2006) had made it difficult to find "excess returns" and that some hedge funds had adopted higher leverage to meet return expectations and thus required tougher risk management. As noted in the EY symposium, the rise of the institutional investor will act to improve hedge fund risk management. Regulators - concerned to avoid systemic risk - are also watching leverage. The RBA's concerns were covered in an earlier blog on this site titled Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk.
A key thread in the study is concern about liquidity and valuation. While these are important matters they tend to relate to the minority of strategies; the majority of hedge funds invest in equity long short or market neutral where investments are made in listed markets. In this sense, liquidity and valuation are more of a concern for private equity funds than they are for hedge funds. In Australia, retail funds are required to meet disclosure standards that should deal with these concerns.
Deloitte found that 78% of respondents used an administrator to calculate Net Asset Value (NAV) and 47% used independent third party pricing. However, it's the intersection of these two that is key - how many funds rely on internal pricing of "hard to value securities" - and this is not clear in the study. Fifty seven percent of respondents had valuation committees, although as with third party pricing, these committees have greatest value where hedge funds are taking on the responsbility of pricing "hard to value securities" internally and have less value where investments are exchange listed and valued by the fund's administrator.
Thus, the emphasis on valuation risks in the study may not be justified as for the 22% of respondents that calculated NAV in-house, no measure of "hard to value securities" were attributed and 15 percentage points of this group relied on a separate back office to strike NAV. The 7% of respondents that relied on the fund manager to value is of concern.
A useful framework for a Valuation Policy was provided in the Survey:
1) to the extent practical, establish a pricing function that is independent of the portfolio management function;
2) describe current valuation methodologies and the process for revisions and sign-offs;
3) establish when exceptions to the pricing policy are appropriate, how such exceptions should be authorised, and ensure that exceptions are documented;
4) provide for backtesting and checking the accuracy of the pricing data that are being captured;
5) establish roles and responsibilities of the valuation committee;
6) establish clear governance and controls structure; and
7) be clear to all parties responsible for its application.
The Survey also covered the use of hedge fund risk management tools. Here great care needs to be taken in interpreting the results. The use of a particular set of metrics may indicate an awareness of risk, but may not be sufficient. For example, a number of prime brokers include risk metrics as part of their offering. Clients of these prime brokers could argue that they employ say a Value at Risk measure without embracing it as part of the investment process of the firm.
Also, different metrics have different usefulness. For example, 50% of respondents apply country concentration limits. However such a metric may not be applicable for example where investments are global in nature and likely to be highly correlated. Amongst the metrics selected, position limits were most highly relied upon (85%) and with justification.
The study included sensible advise in relation to risk governance, including having a written risk management policy, and operational risk.
In summary, Deloitte have made a positive contribution to the hedge fund industry with the publication of their risk management research study. While the emphasis on valuation risks in the study may not be justified, the authors offer some good advice on improving hedge fund risk management governance.
By Rick Steele