The huge inflows of investible funds into hedge funds has caused some alarms in financial circles recently. Almost every wealthy person, endowment, a private corporation’s retirement fund or a sovereign fund now demands to see a hedge fund manager, sometimes without properly doing any appropriate due diligence efforts. The danger is some of these funds carry undisclosed structural risks. Demand for hedge fund managers’ services is getting higher because investors now prefer hedge funds than other investment types. Fund managers can even impose their own terms on these investors rather than the other way around in years past. Some funds have now done away with the hurdle rate requirement for fund managers.
It is this intense demand for fund expertise that has spawned a few frauds and other financial crimes. Besides the usual investment risks (external) associated with a fund’s investment strategy, there are also operational risks (internal) which potential investors should be aware of and form part of their own due diligence process when selecting a hedge fund. Operational risk is sometimes described correctly as the only risk that has no corresponding reward whatsoever. It is considered a “ticking time bomb” because many hedge funds do not have the proper operational procedures in place. This new critical look at hedge funds’ operational risks is partly because of the rapid inflow of institutional funds and partly of some sensational cases of fraud which victimized some of the most sophisticated investors. Some hedge funds do not operate quite optimally because of weak internal controls, frequent errors, and poor information. Many hedge funds are boutique operations or just small private offices and have not matured yet into institutionalized money managers with an adequate operations infrastructure that can protect investors’ assets in a safe manner. Any investor is well advised to look at these 5 areas critical to any hedge fund’s operations:
1. Adequacy and experience of its operations personnel – all hedge fund managers should have a capable assistant to run their day-to-day management operations and allow him to focus on the task of generating returns for the fund itself. The assistant can be designated as chief finance officer (CFO) or as chief operations officer (COO) to oversee both operations and settlement staff as well as review in detail such functions as chasing outstanding confirmations, settlements, cash reconciliations, trade positions, and trade breaks. This prevents frequent mistakes.
2. Degree of Compliance – a compliance manual should be made compulsory so that all personnel are adequately monitored. This helps to ensure that all policies are clearly understood and enforced in such areas as personal trading, trade errors, soft dollar commission usage, and knowledge of customer check payments. Any officer can be designated as a chief compliance officer (CCO) to forestall fraud and abuses.
3. Internal Controls and Procedures – strict internal control systems should be put in place over each stage of the trading cycle: trade authorization, execution, settlement, reconciliation, and accounting. This is advisable for hedge fund firms which trade in big volumes of stocks. Dual signatures should be required for wire transfers and also for cash or asset movements outside of the fund itself.
4. Portfolio Pricing Mechanisms – asset valuation is a significant operational risk as this is one area that is vulnerable to manipulation by the fund manager. It can be used to artificially boost the fund’s performance or even used to hide trading losses. Hedge fund investors can insist on independent well known third-party fund administrator (outsourcing) to compute for the net asset value of the fund. In the absence of outsourced valuation providers, it is imperative to follow 3 widely-adapted best valuation practices: transparency, consistency, and independence
5. Quality of External Service Providers – these providers are the auditing and valuation firms that add integrity to the fund’s reputation. Hedge funds should be audited independently by auditing firms experienced with hedge funds operations. The valuation firms should be big enough to have resources to invest in the needed IT infrastructures, to hire high-calibre auditing staff and also to spend on training programs about industry developments.