THE RISK MANAGEMENT strategies of many hedge funds are out of step with the rapid growth in their size and complexity, according to a global study.

Consultants at Deloitte have identified nine areas where many hedge funds are not following best practice in risk management.

Dubbed ‘red flags’, they broadly cover trading limits, stress testing, liquidity analysis, backtesting and an understanding of leverage. Deloitte says any hedge funds that don’t meet these tests should be looking closely at their risk strategies.

The survey of 60 hedge funds found the biggest area where they are lacking is holding assets with embedded leverage such as derivatives without measuring off-balance sheet leverage, which 50 per cent of respondents had failed to do.

“One group of respondents that should certainly track off-balance sheet risk are those that hold off-balance sheet derivatives with embedded risk, such as forwards, futures, swaps and other derivatives,” the report warned.

This was closely followed by hedge funds using ‘value at risk’ models, which test market and credit risk embedded in a firm’s investments, without stress testing and correlation testing of their liquidity and leverage measures.

Sixty per cent were found to monitor balance sheet leverage and approximately 50 per cent of respondents monitor off-balance sheet leverage for both portfolio and position risk. But Deloitte said these numbers “seem low relative to what they should be, as most hedge funds use at least some leverage”.

Up to 33 per cent of respondents also didn’t track liquidity.

For valuations, while 78 percent were using a third-party administrator or other third party to provide their official net asset valuation, only 47 percent reported engaging a third party to provide independent pricing validation.

“For investors, this means they need to carefully review valuation practices before investing – and continue to monitor those practices once an investment has been made,” the report said.

“Hedge fund advisers that have not yet adopted some best practices need to evaluate if they should adopt these practices in order to continue to attract investors and satisfy regulators.”

The report also found there is very little uniformity in the valuation of various complex or illiquid assets, which reinforced the need for independent pricing validation.

Given the increasing competition among hedge funds, Deloitte predicted the effectiveness of their risk management strategies would become a factor influencing investment in them.

But as risk programs are expensive, they are likely to increase the number of mergers between hedge funds and the consolidation of hedge funds with other financial institutions that already have well-developed risk management programs.