Noted for the risky and exotic nature of their investments, hedge funds actually performed worse last year than the much more conservative Standard & Poor’s 500 Index, which tracks the biggest corporations listed on the New York Stock Exchange. David Marchant, the editor of OffshoreAlert, a leading newsletter on the ins and outs of in the world of offshore finance, reported on this statistic.

Hedge funds returned some 13 percent in 2006, compared with the 15.8 percent return of the S&P 500 Index, according to industry tracker Hedge Fund research, Inc., of Chicago.

However, OffshoreAlert notes that this has not stopped money from pouring into the specialists funds assets under management for hedge funds, which were at a staggering $1.43 trillion at the end of 2006.

Approximately 80 percent of the world’s hedge funds are believed to be domiciled here in the Cayman Islands, with the British Virgin Islands and Bermuda also popular domiciles.

Hedge fund trading activity accounted for up to half the daily turnover on the New York and London Stock Exchanges in 2005, and hedge fund managers typically collect between one and a half and two percent of the assets under management as a management fee. In addition, 20 percent of gross returns as a performance fee if a fund returns a profit.

According to Mr Marchant, hedge funds tend to be complicated and unregulated. He said it should come as no surprise to investors to learn that fraud is one of the principal reasons they fail, as evidenced by such high-profile collapses as Long-Term Capital Management, Lancer Offshore, Beacon Hill, and Amaranth Advisors.

OffshoreAlert reports these failures amid allegations that, collectively, billions of dollars of assets were misappropriated, and that emphasis is necessary for investors and service providers to conduct thorough due diligence, before investing or entering into a business relationship with hedge funds.

Mr Marchant describes some of the nature of Hedge Funds as farcical and adds that at the forth-coming OffshoreAlert 5th Financial Due Diligence Conference, which takes place in Miami, Florida on 24-25 April, a special session on evaluating onshore and offshore hedge funds is being held.

As hedge funds grow in size and complexity, risk management and valuation practices are becoming increasingly important for hedge fund advisers, investors and regulators.

And according to another survey on the funds released this month by professional services firm Deloitte, there is further cause for concern. 

Its study found that half of survey participants hold futures, swaps and derivatives without measuring off-balance sheet leverage.

Sarah Woodhouse, wealth management leader at Deloitte, noted that although the industry is not necessarily headed for disaster, there is a need for better risk management practices.

She added that accurate valuation of assets is particularly important for hedge fund investors when buying or selling units.

“Any mismatch could mean investors either overpay or redeem at less than they should,” said Ms Woodhouse in a release about the survey’s findings. She pointed out that the flood of money looking for hedge funds does not mean managers should relax.

“To attract institutional or superannuation fund assets you really need to ensure you are on top of these issues.”

Regulators in Australia, the US and the UK have been taking a hands-off approach to hedge funds, with the US courts blocking attempts by the Securities and Exchange Commission to require registration.

Moreover, some reports in the international media suggest that those involved in the Hedge Funds business are not too keen on seeing tighter regulations of their product and a large number of funds have reportedly increased their donations to political groups in the US, which some suggest is a way of ‘hedging’ their own bets.

The Deloitte study of 60 hedge fund groups managing 244 funds between US$25 million to US$10 billion, found many are not using best-practice guidelines such as external administrators or independent valuations of their assets.

The lack of comprehensive valuation and risk management data makes it difficult for both investors and hedge fund advisers to answer basic questions.

Deloitte said its global survey showed a disparity of practices with a general finding that while many of the basics are in place, improvements are still needed. 

Another survey, which was published this month, also revealed that new hedge fund launches in the US decreased in funds for the second year in a row. Last year, the 86 largest hedge fund launches raised $31 billion, down from $34 billion raised by 82 funds during 2005 and $40 billion by 81 funds in 2004.

The Absolute Return New Funds Survey for 2006, published in the February issue of Absolute Return magazine, found that most of the launches were in the first six months of the year, and the equity market meltdown last spring and summer hammered hedge funds, the report said.

Only 29 funds raising at least $50 million - the minimum required to be included in the survey - were launched during the second half of the year. These funds raised a mere $6.2 billion, or 20 percent of the total.

The report also noted that seven of the top ten launches were new funds by established players, more evidence, the survey said, that the big, established names will continue to get bigger.