The paper points out that there has been increasing focus on operational due diligence due to the increasing inflows of institutional capital into hedge funds (See Institutional Investment in Hedge Funds to Rise $240B Over Next Three Years ) and some well publicized fraud cases (See Hedge Fund Firm Charged with Fraud Files Bankruptcy ).
In addition, according to the paper, “Regulators are also focusing their attention on hedge funds due to both the tremendous growth of this asset class over the past few years and the increasing demand from retail investors and public pension plans.” (See SEC To Consider Further Hedge Fund Regulation )
The five key considerations for investors listed by the paper are:
- Experience of Operations Personnel – All hedge fund managers should appoint an experienced CFO or COO able to take ownership of the operations function of the hedge fund firm. The CFO or COO should ensure that there are sufficient operations and settlement staff (both in terms of numbers and experience) relative to the size and complexity of the funds under management. Even if middle and/or back office functions have been outsourced, there should be operations staff who have responsibility in assisting and overseeing the service provider’s work in detail.
- Compliance – Every firm should have a compliance manual which sets out key compliance policies in areas such as personal trading, trade errors, know your customer checks, soft dollar commission usage, etc. A Chief Compliance Officer should be responsible for ensuring that compliance policies are being adequately monitored and enforced.
- Internal Controls and Procedures – Robust internal controls and procedures should be in place over each stage of the trading cycle: trade authorization, execution, confirmation, settlement, reconciliation and accounting. Adequate segregation of duties should be present between those who are authorized to trade and those who are responsible for recording trade activity to prevent unrecorded trading losses.
- Portfolio Pricing – There is a risk of using asset valuations to artificially boost fund performance or to smooth “mark to market” losses. Investors can reduce valuation risk resulting from poor operational controls and procedures surrounding the pricing process, by ensuring that the fund is following three best practice principles of valuation: valuation transparency, price consistency and independent oversight.
- Quality of Service Providers – Funds should always be independently audited, preferably by a specialist audit firm with a market reputation for auditing hedge funds. All prime brokers and other counterparties should be high quality financial institutions and there should be transparency in the identities of counterparties that are chosen by the manager.
“Investors must increase their focus on [operational risks] of their investments and not wait for either the regulators or a disaster to alert them to these risks,” the paper says. According to the paper, investors who consider the five key factors will make better informed investment decisions and enjoy more secure returns.
“Hedge Fund Operational Risk: Meeting the Demand for Higher Transparency and Best Practice” can be read here .