Five Steps to Understanding Hedge Fund Operational Risk
As of the second quarter of 2006, assets under management of the hedge fund industry totaled US$1.2 trillion, according to Chicago-based Hedge Fund Research (HFR). For the same period, HFR also concluded that the number of hedge funds was just fewer than 9,000. With this rapid growth in the number and diversity of hedge fund managers, investors must understand the importance of conducting a thorough due diligence assessing the overall merits of a particular manager. Previously the major focus has been on only understanding the investment strategy, however, increasing inflows of institutional capital and the growing numbers of well publicised fraud cases has led to sophisticated investors addressing the operational risk behind their investment.
Regulators and investors alike are paying more attention to hedge funds, as this relatively new asset class is growing at a tremendous pace with keen interest from the retail investor to public pension plans. Therefore it is equally important to understand the investment strategy that seeks risk-adjusted returns, as it is to identify the operational risk that negatively exposes your investment.
The aim of this article is to assist investors in making an informed decision with regards to investing in hedge funds. With the tremendous scope of differing hedge fund strategies that are currently available, investors need to understand where possible weaknesses may lie such as weak controls, poor providers and lacking internal information. Each one of these factors if they are not monitored or resolved can result in a drag on performance. When making an investment decision, you should be well informed on the quality of the hedge fund manager and take comfort that sufficient attention has been given to operational as well as investment issues.
It is important that a hedge fund has a chief operations officer (COO) whose dedicated function is to address all operational issues of the hedge fund. The primary reason for this (especially in smaller firms) is that the trading manager should be responsible for producing alpha, not the day-to-day running of the business. Depending on the size of the firm and complexity of the investment strategies, an experienced COO should be able to solely handle the operation function of a hedge fund with over US$100m under management.
All hedge funds should have a compliance or operations manual, outlining procedures such as; account opening, trading, trade allocations and reporting. In addition to this, the hedge fund should have an industry approved due diligence questionnaire, disclosure document, or similar documentation. It is not a requirement for a hedge fund to be regulated, however, approval by a regulatory body gives a hedge fund greater creditability in this area.
It is essential to understand how a hedge fund has established the internal controls that regulate trading, from execution through to reconciliation and booking to the client’s account. Hedge funds with prime brokers for example understand the efficiency of ‘best execution’ practice with straight through processing capabilities to limit manual interaction. Additionally, there needs to be a clear segregation between those responsible for trading and trade reporting, to limit the possibility of trade discrepancies.
Hedge fund strategies differ greatly but there should be some consistency and standardisation when reporting performance. The manager must be able to explain how the results were calculated and if any fees or interest have been included or excluded. Trade and valuation transparency is crucial if the results cannot be verified by an external organisation. The most effective method to ensure an independent valuation is for the fund to appoint an external administrator.
Selecting premium financial institutions as service providers will strengthen a hedge funds operation through greater efficiency and reduced latency. This should translate into increased returns for the investor, therefore hedge funds that do not disclose who their counterparties or select non-specialist institutions should be avoided.
According to the Basel Committee (June 2004) operation risk is defined as; “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.” The increased attention to this field was motivated by; a growing derivatives market, well-publicised financial losses, as well as regulatory initiatives. With the expanding number of hedge funds and financial opportunities available to investors, understanding the operational risk of any investment must be examined. However, bear in mind that from a universe of 9,000 hedge funds, the top 100 account for nearly two thirds of the entire industry’s US$1.2 trillion in assets (Institutional Investor, June 2006). This list of the 100 largest hedge funds is comprised of renowned and regulated financial institutions.