Institutional investors need to focus more on operational risk processes when choosing hedge fund managers, according to new research.
The full report commissioned by The Bank of New York in conjunction with Amber Partners: Hedge Fund Operational Risk: Meeting the demand for Higher Transparency and Best Practice is available to view at www.bankofny.com .
According to the report, the recent dramatic increase in alternative investments inflows by institutional investors and the rapid maturation of the industry's infrastructure has increased the need for investors to assess the operational systems of their potential hedge fund provider. Investors also need to put into place stringent due diligence procedures to ensure regulatory compliance and to monitor business practices.
Hedge Fund Operational Risk: Meeting the demand for Higher Transparency and Best Practice analyses the five key operational considerations that investors should evaluate:
The experience of operations personnel: The CFO or COO should have ownership of the operations function. There needs to be sufficient operations and settlement staff, both relative to the size of the funds and their complexity.
- Compliance: Compliance guidelines should set out policies in areas such as personal trading, trade errors and soft dollar commission usage.
- Internal controls and procedures: Companies with complex investment strategies, for instance those trading in complex OTC derivatives, will need sufficient staff to monitor long form confirmations. Those organisations trading in heavy volumes should invest in straight through processing capabilities to reduce manual intervention.
- Portfolio pricing: Regulators are seeking more independence of valuations so third party administrators and auditors need to be behind the scenes to verify this independence.
- Quality of the service providers: Funds should preferably be audited by a 'big four' audit firm with experience of hedge fund auditing. It's also advisable to select funds with resources to invest in staff, training and IT systems.
David Aldrich, head of securities industry banking, The Bank of New York, says, 'Investors must increase their focus on assessing the operational risk aspect of their investments and not wait for either the regulators or an unexpected problem to surprise them. They also need to bear in mind that good operational due diligence will help them avoid funds which may suffer a drag on performance due to weak controls, frequent errors and poor internal information. Investors who consider operational factors will make better informed investment decisions and receive more secure returns.'
Reiko Nahum, CEO and founder, Amber Partners, says, 'Hedge fund managers range from small private offices and boutique operations, to deeply resourced institutional money managers with a myriad of variations in between. Exciting investor returns may blind the investor to the true infrastructure deficiencies that can exist behind the scenes. One great bonus for the alternative investment space is the emergence of major outsourcing providers. The resulting robust middle office functionality provided by these outfits is helping fund managers who have outgrown their boutique beginnings access the type of process-driven operating environment that their counterparts in the long-only world have traditionally enjoyed.'
Amber Partners is an independent operational risk certification firm to the hedge fund industry. Amber conducts back office and fund due diligence, providing certification to funds that meet a benchmark of operational quality. Amber certified funds are industry leaders, have a commitment to operational best practice and have responded to investor requirements for greater operational transparency. The company was formed by Reiko Nahum, an expert in the field of operational risk, and is supported by a consortium of shareholders including Bear Stearns, BNP Paribas, certain principals of Vega, Anchor Asset Management and Alexandra Fund Management, a wholly-owned subsidiary of Temasek Holdings, Singapore.