Hedge funds are "disasters waiting to happen", says report

At least 30% of hedge funds have poor risk management that makes them "disasters waiting to happen", according to a report from consultancy Deloitte & Touche.

In a study of hedge fund risk management practices, the company identified nine red flags – areas of risk management where a significant number of hedge fund advisers are falling short of good risk management techniques.

"Not using position and industry concentration limits is a disaster waiting to happen," the study's authors wrote. Of the companies surveyed, 14% did not use position limits and 30% did not use industry limits. The most widespread red flag was a failure to measure off-balance-sheet leverage while holding assets with embedded leverage – 50% of companies surveyed fell short in this area.

Inadequate testing is also widespread in the industry: according to Deloitte & Touche, only 60% of companies perform both stress and correlation testing during portfolio value-at-risk calculations. "Using VAR without doing both stress and correlation testing definitely raises a red flag, since without them VAR does not give a complete picture of risk," the authors commented.

In terms of operational risk, hedge funds are also inadequately prepared, the survey found. Half of all hedge fund failures can be traced to operational risk, but less than half of the funds surveyed updated their operational risk management plans often enough – plans should be updated at least annually, the survey said.

The survey looked at risk management practices of 60 hedge fund advisers worldwide, with a total of $75 billion under management - 6% of the global hedge fund industry.