Each pool of traded financial instruments managed on behalf of outside investors (a hedge fund, a mutual fund or a private equity fund, for example) requires appropriate operational procedures to meet certain operational objectives. These objectives can be specific – that all transactions are recorded accurately on a timely basis, for example – or general – that the fund’s service providers have the personnel, infrastructure and systems to offer a satisfactory level of service. Operational objectives apply regardless of portfolio strategy or fund structure.

Whilst many operational objectives are similar across the spectrum of fund strategies, the overall level of operational risk – the risk that these objectives will not be met – can vary significantly depending primarily on the instruments traded, the size and complexity of the manager, and the fund’s structure. Whilst, figuratively speaking, you may be able to establish an equity long/short fund with a Bloomberg terminal and a mobile phone, the same is not true of a multi-billion dollar, multi-strategy fund where the manager allocates risk dynamically across numerous trading desks and external managers, where the fund invests in a wide range of securities, or where feeder fund assets are invested in multiple master funds and special purpose vehicles.

A fund of a certain level of complexity presents an inherent level of operational risks and requires operational procedures to mitigate those risks. These operational functions may be performed by the manager, administrator, managed account platform or investor. The important thing to note here is that moving operational responsibilities from one service provider to another does not materially affect the overall level of operational risk. In fact, operational risk may be amplified due to the increase in the number of parties involved in the process. Regardless of the distribution of operational functions between different service providers, the level of operational risks across the structure, and the procedures needed to counter those risks, remain the same. Changes in service provider arrangements do not cause operational risks to diminish or disappear; the risks are simply moved from one place to another. The more scientifically minded amongst you might think of this as the ‘law of conservation of operational risk’.

Hedge Fund Operational Risk
Traditional structure
Aside from managing the portfolio and the associated portfolio risk, the operational responsibilities typically undertaken by the hedge fund manager are quite considerable. Diagram one shows an example of the principal operational tasks typically undertaken by the manager in a traditional hedge fund structure. This diagram does not go into the detail of the underlying processes; it’s simply a bird’s eye view of the manager’s operational workflows.

Fig.1 can be split into three key areas. First, through the centre, the principal workflow; that is, those procedures required to allow an entity to fulfil its basic function. In the case of a hedge fund, that basic function is the taking of investment positions on behalf of investors so as to allow those investors to benefit – all being well – from subsequent changes in the value of those investments. Thus, the principal workflow comprises all steps necessary to enter into investment positions, to maintain those positions, and to close them down when they are no longer required; also, all steps necessary to allow investors to invest in the fund, to maintain their investment, and to divest when they want to. Second, the base of the diagram describes the underlying organisation, personnel, infrastructure, systems and procedures required to support the principal workflow. Finally, the top of the diagram illustrates all interactions between the manager and the fund’s counterparties and key service providers.

Of course, this diagram shows only the operations of the manager. Key to the effective operation of a traditional hedge fund structure are the structure and governance of the fund, the operations of the administrator, and their interactions with the manager and one another.

In a traditional structure, there can be significant overlap between the activities of the administrator and manager, particularly in middle office and accounting functions such as reconciliations, portfolio valuation and NAV calculation. In addition, a full service administrator will allocate profits at the investor level, calculate fees, handle subscriptions and redemptions, issue investor statements and maintain the fund’s shareholder register. Also, the administrator may action, or take part in actioning, third party cash payments on behalf of the fund.

The independent overlap of operational responsibilities with the manager is important. Hedge fund investors trade in and out of the fund on an accounting number. Across all the economic transactions undertaken in a modern economy, that’s relatively rare. With potentially millions of dollars at stake at each month or quarter end, it’s imperative that that accounting number is correct. Unfortunately, the calculation and reporting of the NAV is a complex and, to the outsider, an opaque process with numerous subtleties which makes it prone to potential error and manipulation. An effectively controlled NAV calculation process reduces the risk of miscalculation or deliberate misstatement through the independent performance, or replication, of key operational tasks such as reconciliations, portfolio valuation, fund accounting, investor allocations, the computation of fees, and the compilation and distribution of investor statements.

Hedge Fund Operational Risk
Managed account platform structure
From an operational perspective, accessing hedge fund strategies through a managed account platform rather than through a traditional structure means effectively transferring responsibility for certain operational activities from the manager to the platform. Whilst the manager’s responsibilities may be much reduced, the operational risk associated with the manager’s remaining procedures has not disappeared (see Fig.2 for example manager workflows under a platform structure). An institutional investor investing through a platform should conduct a thorough operational risk review on the underlying manager to understand its procedures in respect of key elements of the trade flow, the quality of its staffing and infrastructure and certain elements of its compliance programme.

The scope of functions ‘transferred’ from manager to platform can be quite broad (see Fig.3 for example platform workflows). Fundamentally, under a platform structure, control of the fund’s assets is effectively ‘transferred’ from the manager to the platform. In line with this, the platform may take responsibility for the negotiation of counterparty agreements, counterparty credit risk monitoring, collateral and liquidity management, account opening procedures, the authorisation of fund expenses and asset transfers. For a commingled platform fund, the platform must also take responsibility for subscriptions and redemptions. In order to maintain a clear segregation of duties between staff responsible for the control of investor assets and those responsible for recording, reconciling and reporting, the platform must either engage a competent, independent, full service administrator, or provide a robust, independent, internal fund administration service for its managed accounts.

The scope of the service provided by an affiliated administrator should be similar in scope to that provided by a full service administrator. Full transaction level accounting records should be kept on behalf of the fund or account. Portfolio positions should be reconciled to counterparty and custody statements and valued using reliable third party sources at each dealing date. Non portfolio items such as fees and expenses should be accrued in accordance with invoices and contracts. Detailed profit / loss allocations should be performed down to the investor level. Where applicable, the affiliated administration unit should have primary responsibility for processing subscriptions and redemptions, anti-money laundering procedures, and the maintenance of the shareholder register. The administration unit should transmit periodic statements directly to investors.

The effectiveness of a fund administration function provided internally by a managed account platform requires competence, resources and a suitable organisational structure. Staff should have appropriate qualifications and enough experience to supervise the most complex funds on the platform. There should be sufficient staff to deal effectively with the level of work required and they shouldbe supported by IT systems able to handle the funds’ transactions. As control of the fund’s assets has been transferred to the platform, the affiliated administrator should form a separate unit and be, preferably, physically separate from the rest of the organisation. Staff need clear and separate reporting lines and the ability to escalate issues within the unit to a senior level, quickly and without interference. Senior administration staff should be a senior level within the firm, highly qualified and experienced, and must understand the importance of their independence, and of segregation of duties, to the organisation, its investors and managers.

To pass an Amber Partners’ review, a platform must demonstrate policies and procedures to reduce sufficiently the risk of theft and fraud, the risk of a material misstatement of NAV, and other key operational risks. Platforms that have failed Amber Partners’ operational risk review in the past have demonstrated a number of weaknesses including senior accounting staff with inadequate qualifications or experience; failure to maintain full transaction level accounting records; weaknesses in the capture of fund transactions; insufficient systems for maintaining shareholder records; lack of full trade level reconciliations as at each dealing date; reliance on hedge fund managers to reconcile accounts; a failure to value independently all portfolio positions as at each dealing date; no clear responsibility for the NAV process; and, no review of the NAV calculation at each dealing date.

Conclusion
Accessing hedge fund strategies through a managed account platform does not eliminate the operational risk associated with the investment. In fact, introducing a new service provider into what is quite an intricate process can act to increase complexity through increasing the total number of interactions required to complete the various operational processes. Hedge fund investment is operationally complex regardless of the method of investment and a full operational risk review of a managed account platform is an important element to mitigate operational risk to the end investor.

Gareth Jones is a Director at Amber Partners. His role includes the delivery of operational certification and consulting services. Prior to Amber, Jones was CFO for a structured investment vehicle. He began his career at Ernst & Young in its Capital Markets Group.