"What knavery is this?" Turbulence puts potential pricing jacknapery in limelight, as investors seek risk control discipline

If you didn't have risk management foremost in your mind before July, chances are you do now. Kinetic Partners' Nick Matthews lists the questions to ask now, to avoid legal battles later...

The current turmoil in global markets will have elicited a range of responses from different hedge fund managers. Some will be clapping their hands - volatility can be the lifeblood of some hedge funds, after all. Others will be staring at their screens in horror.

What is certain, is that no hedge fund can ignore the market rollercoaster that first affected credit market before spilling over into equities. With some high profile banks - Bear Stearns, Goldman Sachs and BNP Paribas among them - either cutting their losses and winding up hedge funds or injecting new capital to help them survive, it is clear the global hedge fund industry faces its greatest challenge since the collapse of Long Term Capital Management (LTCM) nine years ago.

What has changed since then, of course, is that the industry has grown exponentially in size and influence. A meltdown in the hedge fund sector could have disastrous knock-on effects in the global financial system.

Most commentators agree that such a meltdown is, mercifully, unlikely. After the initial days of panic, central bank interventions helped stabilise the markets and fears of a global crash retreated. There is also the comfort that innovation in financial products has led to risk being spread more widely than in the past.

Nevertheless, it continues to be true that there remains a great deal of risk within the financial system, and that not all of it is understood or correctly priced. The onus on funds, and the investors who entrust their money to them, to understand their risks and manage them effectively has never been greater.

There is also a much bigger prize at stake: multiple hedge fund failures would only intensify efforts by governments to regulate the hedge fund sector more closely. This would be a disturbing development. No-one wants a Sarbanes-Oxley Act for this industry.

Hedge funds are feeling the pinch from current market conditions in two ways. There is a greater need for cash to meet margin calls, due to portfolio movements, and an increase in redemption requests. In addition, many funds will have suffered a severe decline in performance.

There may be temptation, under such conditions, to engage in inappropriate, unethical or even illegal behaviour.

Managers may seek to manipulate their net asset values, so as to give a rosier picture of their current worth than is warranted, or if managers have been forced to sell more liquid positions to raise cash, they may be sitting on a rump of complex, illiquid and hard-to-value investments. (For more on this see page 15.)

One notable feature of the recent market woes was the lack of clarity over who was sitting on losses, and how big those losses were. The explosive proliferation of products over the past few years saw the creation of numerous securities that can only be valued accurately when traded. It is worthy of note that BNP Paribas halted redemptions on its funds because it said its positions were "impossible to value."

Consequently, some hedge fund managers continue to have considerable influence in determining the value of their funds, and if they can avoid selling hard-to-value instruments, they can continue to present overly optimistic valuations.

The ratings agencies have also said they have difficulty ascribing an accurate value to the complex products favoured by many funds.

While concealing its true state of health from the market and investors, a fund may be tempted into drastic action to make up the shortfall.

Managers may be tempted to take on additional risks by trading outside their mandate in an attempt to recoup losses quickly. This alters the fund's overall risk profile and may hasten its demise if the greater risks crystallise. The industry has seen more extreme cases where a separate account was established in which losses are hidden, preventing them from dragging down overall performance.

Worse still, desperate managers might manipulate the market with rumours that would boost the value of a particular holding or be tempted to make use of inside information.

This last option, aside from being illegal, raises considerable reputational risks for the fund concerned. The UK's Financial Services Authority (FSA) has re-affirmed its intention to focus on insider dealing and market abuse, pledging to take robust action against individuals and even bring down firms if necessary.

The UK government may well arm the FSA with plea bargaining powers to achieve this.

Nor will the FSA be alone in wielding prosecutorial powers. The Fraud Act 2006, which came into force in the UK earlier this year, makes criminal prosecutions for fraud in the financial services sector more likely.

Until the Act was passed, English law had no single definition of fraud; the regime has now been simplified and three main offences - fraud by false representation; fraud by failure to disclose; and fraud by misuse of position, have been introduced. Each offence carries a potential 10-year jail term.

For hedge fund managers, the first and third of these offences in particular may be relevant; the recent market turmoil and associated deterioration in performance for many funds makes false statements or an abuse of a fund's right to self-value more likely.

It is not just in the UK where the regulatory and enforcement environment is hotting up. In the US, the Securities & Exchange Commission has adopted a new anti-fraud rule under the Investment Advisers Act 1940, making it an offence to defraud investors in pooled investment vehicles. The new rule comes into effect on 10 September. Any regulatory intervention is likely to be costly, high profile, and highly damaging in terms of the hit to reputation - a fund will not easily be able to dismiss a rogue trader and move on. In addition to the reputational damage, funds that fall foul of the law can look forward to probable legal action by investors or the liquidators acting in their name.

Given these very considerable threats, what new risk management tactics should the chief executives and chief risk officers of hedge funds be considering? Current market conditions make it a key time to revisit internal controls and ensure their efficacy.

In particular, firms should review positions, and position limits, with individual portfolio managers to identity any potential exposure to the market's fluctuations.

Firms should also look at how individual managers have traded recently - is there a clear justification for their trading patterns, does it tally with the fund's overall strategy, and is it in line with mandate limits? Such questions, asked early and firmly, can stave off far greater problems later down the line.

Similar questions should be asked of margin calls - are they consistent with known positions, or could there be hidden losses which are being funded? Depending on a hedge fund's specific strategy, senior managers should have a clear idea of their exposure to current market conditions. If trading results appear to be much better than anticipated, then managers should take a closer look. If something looks too good to be true…

After the collapse of Amaranth last year, the market was generally quite pleased with itself because a substantial market correction was averted. A similar mood persists today. But, such complacency should be challenged. Just because the hedge fund industry, for the most part, appears to be weathering, the storm does not justify inaction and although there has not been a full global crash, perhaps we should pretend that there has.

Risk needs to be understood and due diligence by investors needs to be a thorough, intelligent interrogation, not a box-ticking exercise.

If the current market turbulence results in those lessons being rammed home to hedge funds and their investors, and if greater regulatory intervention in the sector can be headed off, then perhaps it will have proved to be a valuable - albeit exhausting - few weeks for the industry.