Hedge funds: the emerging focus on operational risk
The media frenzy surrounding the recent collapse of two well-known hedge funds, Amaranth and Archeus, highlights the risks associated with the Alternative Investments sector. Commentators ranging from the European Central Bank to the FBI have voiced their concerns over this unregulated, yet increasingly powerful force in the financial markets. Yet despite the risks, this sector continues to grow exponentially as investors are drawn to hedge funds proclamation of stellar returns and capital preservation.
The hedge fund industry provides a striking example of the different types of practitioners that can exist - from one-man-bands to fund management companies resembling institutional investment banks in scale and operational capability. This diversity highlights an often overlooked truth behind the hedge fund industry. Many hedge fund managers have come from large investment banks or asset management houses where they relied on teams of professionals dedicated to trade reconciliations and the generation and checking of accounts. Replicating this level of support and back-office functionality is not easy, or cheap, or even necessarily their priority. And here-in lies the problem - operational capability eats into a fund manager's profit margin and can therefore often be neglected. Yet a robust infrastructure is fundamental to the success of a hedge fund. It is therefore essential that an investor is familiar with this capability and satisfied with its efficacy prior to investing.
The analysis necessary to ensure this familiarity concentrates on the fund managers operational capabilities and risk management resources. The impact of inadequate resources is highlighted by the recent closure of Archeus, which managed $3 billion at its peak, and which has since pledged to return its money to investors. Archeus' CEO and CIO, in a joint statement, claim that they "have not been able to overcome the negative sentiment which has snowballed as a result of our third party administrators failure to properly maintain the books and records of our fund - this failure, and [the administrator's] inability to properly reconcile the funds records, led to a series of investor withdrawals from which we have not been able to recover". In the current climate, even the hint of an accounting irregularity has proven to be enough to contribute to the demise of an established and highly regarded fund.
An assessment of Archeus' operational capabilities may have raised some warning flags. For example; was there enough experienced staff to manage the volume and complexity of trades that were being booked? Did Archeus use computer systems that could adequately track the deals on their books? Were there adequate communications channels open to resolve issues when they arose? Was the administrator a reputable one? Were Archeus internal trade reconciliation processes adequate?
Another hedge fund to have collapsed recently was Amaranth. Here the $6 billion in losses resulted directly from incorrect directional trading. However, thorough analysis of Amaranths infrastructure and processes may have rung some alarm bells. For example, was their trading arms geographical dislocation from their compliance / risk management function a sensible approach? Were their risk management limits sufficient to prevent significant concentrated exposures to particular market movements? Were their internal controls adequate in identifying these risks? These are questions any prospective or existing investor should have been asking.
Situations such as these have brought operational considerations to the fore; indeed investment banks are now beginning to quantify their exposure to operational risk. From an investors point of view, this is an area that will attract increasing focus if for no other reason than this is the only risk that an investor will become exposed to that does not bring the benefit of potentially increased returns.
The more detailed the due diligence into all aspects of the running of the fund, the more representative a feel an investor will have for the risks that they are exposing themselves to by entrusting assets to a fund for management - operational risk being just one example. At Nedgroup Investments we have an independent team analysing operational risk, and with the power to impact upon our investment decisions. We know that a static analytical process is unable to adequately deal with this rapidly developing market, and have periodic reviews of our procedures, in combination with interim reviews in the event of major hedge fund blow-ups.
It is not our contention that analysis and due diligence will always be able to identify those funds which will fail, although to date Nedgroup Investments has avoided exposure to any such fund (indeed our processes have enabled us to identify, and avoid, certain funds that have subsequently collapsed). As the industry continues to grow in size and maturity, lessons are being learnt and even if not (yet) enshrined in regulator-driven rules, standards and best-practice guidelines will emerge. In the interim it is up to the more professional and diligent market practitioners to lead the way.
Ben Keefe, Nedgroup Investment Advisors (UK) Limited
