As a manager from one of the traditional houses observed, "We aren't winning business on the basis of our operational strength, because nobody asks about it. They ask weak questions which anybody can say yes to. They need to be educated to ask harder questions and demand proof."

Over the last five years, traditional fund managers have become increasingly interested in setting up hedge funds. By the end of 2004, fifty of them had done so in Europe, creating funds which make up around 15% of the overall industry [see Figure 1]. It is common for specialist operators to dismiss these new entrants as lumbering dinosaurs, bringing mediocre talent which will dilute the pool of returns and diminish the attractiveness of hedge funds as an investment class.

But what factors do these companies offer which could differentiate them and make them attractive, particularly to some of the newer, more risk-averse hedge fund investors? And conversely, what questions should investors be asking to understand the relative strengths and weaknesses of these companies? Are investors scrutinising operational excellence as carefully as they examine investment excellence?
 

As they make their first entrance into the industry, these companies have a very different business proposition to most startup hedge funds. Like a startup, they are looking to acquire a new set of assets to invest in a new and exciting way. Unlike a startup, they already have a business engine which they are looking to leverage. Staff, premises, networks, finance and admin teams, corporate lawyers, branding and sales teams are already in place. A lot of work still has to be done in preparation for the launch but crucially, very little of this has to be done by the selected fund manager [see Figure 2]. During and after the launch period, the manager can concentrate on running money and not on running the business, although they may also have to keep running existing funds. How does your due diligence process uncover the manager's real mix of responsibilities?

Inside the business itself investors should benefit from the presence of routine habits of regulation. Nearly twenty years after Big Bang, fund managers and regulators have clearly defined roles in protecting investor interests. Where the hedge fund industry has opted for demonstrable third-party fund valuation and pricing, retail fund managers are accustomed to being responsible for producing fund values to a high level of quality and reliability. Whether outsourced or insourced, these valuations are created and scrutinised daily, as significant errors in pricing require a complex process of compensation for investors. Are you asking how the company manages its administrator, or just who the administrator is? Do you understand how the valuation the manager uses for investment purposes matches the valuation which investors receive? Do you ask about who is responsible for reconciling the administrator and broker records, and how often this happens?

The corporate strength of the company could also provide some comfort. Most traditional fund management companies are now owned by banks or other financial services firms; companies who would keep a sharp eye open for any fraud or accounting irregularities and who would also have the deep pockets necessary to make investor compensation should the worst happen. These companies are very aware that the launch of hedge funds represents an unspoken commitment on their part to resolve any issues in order to protect the brand across all products. In many large fund management companies the million pound error has happened in the past, and they work hard to prevent it happening again. With 50% of all hedge fund failures estimated to be due to operational failure, this could be a major risk management factor for investors. Do you take this into account when investing? What evidence of internal management controls do you look for?

As the fund develops, it may want to expand the range of instruments it invests in. Traditional companies have an approval process in place for this which ought to scrutinise the operational readiness to process the instruments, as well as verifying the appropriateness of the instrument for the fund. With the current surge of interest in swaps and OTC instruments, are you convinced that your chosen managers are only using instruments they are completely able to understand and process? Do they have independent pricing and management from their broker – who is, after all, recommending these investments? How are they handling the rising tide of paperwork from these very manually-traded instruments? Is thisactually more of an issue in a larger firm where the volume of trades may be building up very quickly from the non-hedge fund parts of the fund range?

Once the fund is underway, are you really sure that what you are buying is what you are getting? Traditional fund managers are increasingly being asked to provide evidence that their stated investment strategy actually turns up in the portfolios. Performance attribution reports can be created which are directly aligned to the investment philosophy so that they can demonstrate how the performance was actually generated. The hedge fund industry is often reluctant to provide detailed lists of holdings, citing a two-fold argument that sophisticated investors could use the information to invest against their positions, and that unsophisticated investors wouldn't know what the information actually means. Consequently many funds are moving towards style-based reporting, to illustrate that there has been no investment drift. But is this providing the level of information investors actually need?

And finally, in contrast to a single specialist fund, the business managers can afford to be dispassionate about individual funds. With a large number of fund managers clamouring to be granted a hedge fund, the company can create a continual process of creating, supporting and eventually terminating funds. As many fund managers have periods of outperformance which may be followed by periods of underperformance, these companies can argue that they are better at monitoring and terminating underperforming funds rather than waiting for investors to vote with their feet. Are they? What track record do they have of terminating funds, on both the long-short and long-only sides? Have they been able to transfer funds from one manager to another?

It is up to investors to make sure that they can understand the difference between an operationally excellent company, and one which really exists only for the joy of managing money. There must be no automatic assumption that bigger is better or that stellar performance will allow funds to trade themselves out of any problem – investors must concentrate on investigating the detailed risks which they are taking on and balancing that against the potential gains.

Catherine Doherty is a Principal Consultant in the Systems practice at Investit, and wrote the recent Investit Intelligence research paper "Hedging Your Bets? – Mixing Long-Only and Long-Short Investment." She has been working on investment management systems since 1987, in areas ranging from expert systems through to company integration management and strategic systems planning. Investit Intelligence is the only research service which examines the operational aspects of running investment companies – the prosaic "how" which has to follow the glamorous "what".