As hedge funds grow, so does risk

From fraud to exotic instruments, funds face varied risk management challenges

Jojo Puthuparampil

As hedge funds manage increasingly vast, complex and exotic portfolios, there is a growing concern about portfolio managers' risk and compliance officers' understanding of their risk exposures.

Over the past five years, the number of hedge funds has doubled, to more than 8,000, and total assets under management are approaching $2 trillion. This creates stiffer competition, which puts pressure on managers to take bigger risks or skate toward the edge of fraud or other malfeasance. According to Mark Sunshine, president of West Palm Beach, Fla.-based First Capital, which provides credit services for hedge funds, potential areas for fraud include misreporting assets, inflating returns, violating laws and regulations, ignoring disclose liabilities, and failing to follow the fund’s investment thesis and guidelines.

"Fund manager fraud is the number-one reason for serious loss—defined as greater than 50 percent—in a hedge fund," says Sunshine. "Because this is essentially an unregulated industry, there is little timely oversight of the managers."

There are also risks associated with self-dealing, which happens "when fund managers make investments with their personal money or the money of the fund management company," instead of the fund's money, explains Sunshine. "They then favor their personal investment over the investment  of the fund."

Managers can also hurt their funds by deliberately misstating the value of their portfolios or taking unacceptable risks. Anna Pinedo, partner at law firm Morrison & Foerster in New York, says that insider trading can also result in legal repercussions for hedge funds. "There have been a number of enforcement actions [by the Securities and Exchange Commission] against hedge funds and their principals for insider trading and market manipulation issues," she notes. "These actions are a good reminder to the hedge fund community that it is very important to have internal compliance procedures and for personnel within hedge funds to monitor internal adherence to the compliance procedures."

Exotic Investments

As the hedge fund landscape gets more crowded, funds look further afield for investment opportunities, pushing into areas such as credit derivatives and structured products. These highly customized, non-standard instruments can add risks that a manager might not even be aware of.

"Often, derivatives and structured products have a built-in leverage or gearing effect, which may make the effect of a change in an underlying or reference asset more severe than otherwise," says Pinedo. She stresses: "A thorough understanding and careful review of each product is required in order to be certain that the people at the hedge fund who are monitoring the portfolio understand the risk exposure under each derivative contract or structured product."

If hedge funds enter into back-to-back swaps or other derivatives contracts, there may be legal and business risks if the terms of the back-to-back agreements do not line up perfectly, she adds. "This is particularly true in the credit derivatives area where default and triggering events may not align," says Pinedo.

Lack of understanding is also an issue when it comes to correlating risks across asset classes and geographies, says Sunil Pai, chief information officer of Palm Beach Gardens, Fla.-based hedge fund ST Capital Partners. "The world has become much smaller in recent years, and there are a number of risks that have become or have the potential to become very correlated," he says. "Many newer hedge funds are run by inexperienced individuals—many coming out of big Wall Street firms—who have not lived through an event such as the hedge fund crisis in 1998 or the stock market crash in 1987. "These individuals may not be asking the what-if questions that are essential for adequate risk management," notes Pai.

Counterparty Risk

"Investment banks with large prime brokerage operations and commercial banks act as counterparties and creditors to hedge funds. They facilitate the implementation of many of the hedge fund managers' strategies and provide the capital that enables managers to leverage their exposures.  Concerns about counterparty risk management have become more pronounced with the increasing complexity of financial products," said Federal Reserve Board chairman Ben Bernanke at the Federal Reserve Bank of Atlanta's Financial Markets Conference in Sea Island, Ga. on May 15. "Complexity—especially when combined with illiquidity—amplifies the difficulty of measuring market and counterparty credit risks," said Bernanke. "The problems of valuation and of risk measurement faced by investors in tranches of bespoke collateralized debt obligations [CDOs] are a good example. Similar problems are faced by the core financial intermediaries that often act as counterparties to hedge funds in complex synthetic CDO transactions."

Given increasingly risky investments by hedge funds, banks may have the most to worry about, but hedge funds need to keep an eye on their counterparties as well, especially if the funds are straying far from their home territories.

"Funds must evaluate the creditworthiness of their counterparties," says Steve Howard, an attorney in the New York office of Thacher Proffitt & Wood. "If the counterparty goes bankrupt, the fund may not be able to recover its investment."

According to Sunshine of First Capital, some funds are producing high returns through excessive leverage. The higher the leverage, the greater the potential returns and the higher the risks. With ordinary borrowing, it is relatively straightforward to assess the degree of risk associated with an investment, but leverage can take many forms.

"It's much more than just debt," says Sunshine. "It includes derivative contracts, delayed settlements, swaps and options, and other synthetic instruments."

Morrison & Foerster's Pinedo notes that many complex financial instruments include embedded leverage as a feature. The embedded leverage not only increases risk in a hard-to-quantify way, but can also make the investment less liquid. As hedge funds come under increasing pressure to shorten lock-up periods, these instruments can create problems. "It may become more difficult to meet the short-term demands on the part of investors for redemptions," says Pinedo.

Valuation Difficulties

Hedge funds with investments in complex and illiquid securities may fail to accurately assess the value of their assets. The more complex the investment, the trickier the valuation process. For example, hedge funds need a more accurate means of valuing over-the-counter derivatives, Pinedo says.

There are inherent conflicts of interest in valuation, Pinedo points out, such as the strong economic incentive for hedge fund managers to overstate the value of a portfolio, since their fees are tied to returns. Valuation of positions for which market prices are not available also poses severe risks. It's important for a hedge fund to have standardized procedures and adequate oversight when it comes to valuation, she says.

According to Sunshine, lack of systems and infrastructure causes problems for many hedge funds. Technology costs money—which cuts into the bottom line. And so does management oversight. "Many fund management companies do not have adequate staff to manage their assets during an economic slowdown and are at risk of losing control of their investments if the economic tide starts to go out," Sunshine says.

Hedge funds must have appropriate systems to monitor and limit exposures and provide disaster recovery capabilities, says Pinedo. They must also have compliance policies to limit exposure and to segregate functions and activities among the front, back and middle offices.

"Operational risks are quite serious," she says. "Many hedge funds have grown very quickly and have not developed the systems and controls and procedures to keep up with their growth. Moreover, hedge funds generally are led by traders, who may not be accustomed to functioning in an environment where there are rigid internal controls and procedures."

Inadequate staffing creates other problems. "Fund performance in many cases is determined by the performance of a small group of people—in some cases one key individual," says Howard of Thacher Proffitt. "The fund could be harmed if key individuals leave or otherwise no longer manage the fund."

In this and other areas, size can be an advantage, says ST Capital's Pai. "Costs for regulatory compliance are going up while operational and debt funding costs are generally going down," he says. "Larger hedge funds have an edge in obtaining the best trading and fund-administration cost levels."

(This report was written for a New York-based news syndicate after speaking with US-based financial analysts)