Hedge Funds Increasingly Taking on Risk

As the hedge fund industry becomes increasingly crowded—the number of hedge funds has doubled over the past five years to 8,000—hedge fund managers are taking on more risk and some funds may turn to fraud, sister publication Securities Industry News reports.

Ways that hedge funds may commit fraud include misreporting assets or returns, self dealing, insider trading and failing to disclose liabilities.

“Fund manager fraud is the No. 1 reason for serious loss, defined as greater than 50%, in a hedge fund,” said Mark Sunshine, president of First Capital, which provides credit services to hedge funds. “Because this is essentially an unregulated industry, there is little timely oversight of the managers.”

Along with the increased chance of risk, funds are turning to such exotic instruments as derivatives and structured products to boost returns. Such products can not only inflate returns on the upside but do the same on the downside as well.

“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,” said Anna Pinedo, a partner with Morrison & Foerster. “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 each structured product.”