Operational Risk toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation

CHAPTER 23

Identifying and Mitigating Valuation Risk in Hedge Fund Investments

Meredith A. Jones

 

 

ABSTRACT

Portfolio valuation and pricing can be a significant issue for hedge funds, from both a strategy execution and an operational standpoint. There have been several instances where failure to thoughtfully value a portfolio has ultimately led to a hedge fund’s untimely demise. This chapter attempts to shed light on the operational issues surrounding hedge fund valuation and pricing. It includes a discussion of the operational risks involved in valuation and pricing, separates operational valuation from strategy-related valuation issues, discusses which strategies are more susceptible to operational valuation risk, and specifies what investors can do to discover and mitigate these risks.

23.1 INTRODUCTION

When evaluating or investing in hedge funds, it is important to consider both strategy risks and operational risks. For most, evaluating the strategy risks involved in making hedge fund investments has become second nature. However, the importance of and skills required for evaluating the operational risks involved with hedge fund investing have only begun getting the same attention in recent years. Operational risk, however, cannot be ignored. In fact, a 2005 EDHEC white paper attributed fully 50% of hedge fund failures to operational issues alone. Certain widely known hedge fund failures, such as Beacon Hill, Lancer Management Group, Bayou Fund, and Integral Investment ...