Hedge funds remain attractive to institutional investors for theirability to use derivatives which provide leverage, hedging capabilities and exposure to underlying global assets. However, the use of derivatives does not come without inherent risk and institutional investors have a penchant to minimize risk whenever possible. According to the Prequin report, risk management is the fourth most important factor for investors when selecting a fund, behind strategy, track record and performance.
Increase in due diligence
Since the credit crunch of 2008, both investors and regulatory bodies have been pressing fund managers to increase the institutional quality and capabilities of their overall information systems. Some regulations seek to control risk and asset exposure (UCITS IV) while qualified investors are thought to be protected by enhanced reporting requirements as seen in Form PF (Dodd-Frank legislation), or new requirements for European funds (AIFMD). Added to this are more rigorous due diligence interviews being conducted by investors before making their asset allocations.
Investors are now demanding increased transparency and granularity around many areas of the investment process. One area of focus is to investigate source of returns and ascertain how some asset classes are monitored and controlled. Detailed questions around resource risk, auditability, pricing policy, robustness of controls and platform infrastructure are all being asked. Investors also check how quickly a manager can respond to external ad hoc reporting requests, particularly in light of recent counterparty failings. Before investing in a fund, investors want to ensure fund managers are able to respond quickly on where cross-asset exposure lies with respect to any attribute, be it counterparty, issuer, currency, country, sector or industry. Managers running their investment processes on offline spreadsheets or multiple systems will struggle with these demands, and yet they are only becoming more onerous – some fund managers go through over 60 due diligence meetings a year.
One of the more common derivative asset classes traded by hedge funds are synthetic equities or Swaps/CFDs. Funds will trade these for a variety of reasons, mainly leverage, emerging market access, transaction efficiencies or to more effectively manage their exposure to underlying assets. Given the contractual nature of these investments, financing requirements, and underlyer investments, managing the full process from tracking, confirmation, reconciliation, to cash management can be difficult. Adding to the challenge are numerous regulations being enacted that require dividend withholdings on underlying assets for US residents, liquidity reporting, reporting on leverage and Form PF (one of the first enacted pieces of legislation from the Dodd-Frank Act – 15th January 2012 for funds with assets over $1 billion under management; 31st March for others). In their due diligence processes investors have started to ask questions about these derivatives so as to better understand how effectively the fund can manage the inherent risks. They are asking about resource knowledge, pricing policy, compliance, financing accruals and settlement, and this means some may not invest in funds that cannot demonstrate appropriate controls over risk or a robust platform to provide timely management information.
For example, a fund that has a single swaps expert who tracks trades, margin and cash on offline spreadsheets may report incorrect valuations, accruals or cash flows all affecting net asset value. These risks may be too much for investor appetite given the levered and derivative nature of the asset class. Investors more and more want to see a proven auditable system that can natively value and accrue Swap/CFD performance and financing detail, thus mitigating operational and valuation risk.
Exposure risk and its rapid assessment has been paramount to investors since the crisis and investors look closely at how quickly a manager can gather accurate exposure information on underlying assets or counterparties. If this process is manual or difficult to collate due to lack of transparency, disparate systems or offline processing, the fund and investors may suffer as accurate underlying exposure and P&L are not made available back to traders for quick market assessment and reaction.
A simple and effective way to solve these challenges is through the use of technology which has native support for the Swap/CFD asset class. The higher the levels of manual intervention (reconciliation, offline processes, pricing) the greater the operational costs. Investors look for demonstrated operational efficiency and the simplest response for a manager to help attract institutional investment is through proven automated platforms with native derivative support. Table 1 summarises the key requirements a fund should consider to increase operational efficiency around the core Swap/CFD asset class.