Making Sound Investment Decisions

New insights in hedge fund investing

Originally published in the November 2010 issue

Today’s asset markets are probably priced for ‘normalcy’, with equity markets on a price/earnings basis at roughly normal levels and credit spreads at or about long run historical averages. The de-leveraging cycle has rolled its way through all sectors of the economy. That is not to say we do not expect markets to move or that we have found equilibrium, however, the world did not end and in fact we are moving forward.

Following the calming down in markets, interest has picked up in hedge funds again. However, many lessons have been learnt from the crisis. One of the main takeaways has been that it is estimated that operational shortcomings are responsible for around 50% of fund failures. There are many reasons for this, which will be touched upon later in this article; however, one of the key reasons behind these failures is the relaxed regulation surrounding offshore hedge funds. Operational risks are an element that investors are not rewarded for when investing. As a consequence, the need to fully research and understand operational issues is paramount prior to investing. Operational risk assessment coupled with a well run management company with a disciplined approach is usually more likely to deliver safer investment performances. What this means in reality is that investors want to better understand what it is they are investing in. It appears that historically in many cases past performance was a goodenough reason to invest. Understanding the legal set-up of a fund, how the fund manager makes investment decisions or ensuring that there is a clear separation of powers was never at the forefront of investors’ investment making process. The revelation of Bernard Madoff’s $50 billion Ponzi scheme had a significant impact on the alternative investment business. Substantial redemptions, fund failures and the disappearance of many hedge fund managers were recorded throughout the industry. The above events highlighted how a vast majority of hedge fund investors ignored, underestimated or ultimately overrode the importance of operational risk. Furthermore, the Madoff affair cast doubt on the independence of the operational due diligence function within certain organisations.

The importance of due diligence
Why is operational due diligence of such importance? With more then two thirds of all hedge funds being domiciled in more exotic locations such as the Cayman Islands, the British Virgin Islands or Delaware, which are traditionally low regulation environments, it is clear that fund documentation and the legal set-up is made for the benefit of the fund and its managers and not for the investor. This is quite different to what most investors are used to, especially when investing in more regulated environments in the long only world. This is not to say that the exotic offshore jurisdictions are bad. What investors need to appreciate is that a lack of common practices or a formal framework to operate from means that a different standard applies and that these standards need to be understood. This is why, when investing in hedge funds, a much higher level of due diligence is required then with traditional long only investment funds.


Evolution of operational due diligence
What has become clear is that the function of operational due diligence (ODD) has evolved from a business support to an investment team function. In the past, research analysts and portfolio managers were the only individuals involved in portfolio construction. Operational analysts would only analyse human resources, the operational issues including middle and back office functions, the service providers and the tools supporting the investment process. Even then this role was sometimes delegated to the investment analyst or even not carried out at all. More recently, the barrier between the investment team and operational due diligence departments has been removed in order to enhance overall knowledge through the sharing of experience and know-how. Rather than assessing operations, compliance or management structures separately, these are now analysed in the context of a hedge fund’s strategy and associated markets risks, with strategy now being a focal point of operational due diligence. However, the independence of this function with respect to the rest of the investment team and maintaining veto rights on investments remain a key role, especially in this new environment.

But we do due diligence!
What has transpired recently, though, is that there are many levels of due diligence to be carried out and that this is now cutting edge work and is not sufficient for a junior analyst to simply fill out some forms and tick boxes. In carrying out due diligence the skill set of a lawyer, an accountant, a risk analyst, a process manager, an investment analyst and in some cases IT specialist are required. Many other sources need to be checked; administrators and prime brokers must be used to corroborate the information provided by the manager. A recent study showed that over 20% of hedge funds misrepresented facts during investor due diligence interviews. In addition to the standard problems other frequent sources of operational risks include counterparty risk, trading complexity, as well as the absence of systematic control of investment restrictions as outlined in a hedge fund’s offering documentation. These all need to be takeninto account, with the aim that funds with lower operational risk remove a risk that investors are not rewarded for. It turns out that the better the roles and functions are defined in a fund organisation, the better the performance often is.

Upcoming challenges
The key factor of future success for the ODD function is to continuously maintain and enhance analysts’ expertise with regards to financial instruments and market strategies, as well as to stay up to date on administrative developments with respect to custody, settlement and inter-related processes. ODD teams have gained legitimacy within the investment community and have to consolidate this position within their organisations. The impact operational concerns may have in the investment decision making process will be critical in order to be able to detect hedge fund frauds in the future. Operational analysts have to be more active in their interaction with hedge fund managers by suggesting the implementation of best practices. Regulatory changes will make a difference going forward; however, investors should also advocate the end of self administration and self custody. There should be a segregation of duties, for instance between portfolio and risk management or portfolio management and compliance. These independent reporting lines need to include a power of veto and the head of operational due diligence needs to have a seat on the investment committee. Finally, thought needs to be given to the background of ODD specialists, requiring investigative and forensic training. To cover those risks efficiently, investors have to keep pushing for transparency from hedge fund managers. Given the uncertainty in the regulatory environment and the discrepancies across local regulations, operational analysts also need to enhance the coverage of the compliance area and stay on top of any changes in regulatory requirements.

Do NewCITS solve the problem?
Many hedge fund strategies already are or will soon be offered via regulated funds structured as European UCITS. Recent changes in UCITS regulation have made this possible. Many fund houses will take advantage of this, especially due to uncertainty surrounding the alternative investment fund managers (AIFM) directive. Moreover, the large houses have the ability to change their existing long only strategies and use their distribution channels to raise new assets, with a potentially interesting new investment story. However, again, investors must know what it is they are getting into. Many strategies will need to be profoundly altered to be structured as a UCITS fund. They will need to shed most illiquid securities, as well as any non-financial assets; they will need to diversify their assets and limit counterparty risk arising from derivative instruments. In addition, UCITS cannot borrow more than 15% of the value of their assets although they are allowed to use leverage of up to 100% using financial instruments and are forbidden from engaging in naked short sales. They will instead create new instruments to short securities. As a consequence, the offshore fund will only incur borrowing costs; the UCITS fund will also incur some sort of product development margin as well as the borrowing cost. Due to the investment restrictions laid down by regulation, investors will feel more relaxed. Nevertheless, funds can, for example, still impose a 10% gate and it may also be that a security that is currently liquid may all of a sudden face illiquidity. It is unclear what would happen then. This is not all bad. There is clearly a more robust framework provided for investors with legal certainty as to how the fund will invest. Although it is expected that turning offshore hedge funds into UCITS will lower returns the long-term effect remains yet to be seen. Having said all of this, there are still some areas of uncertainty. One of the reasons for wanting to invest in a NewCITS fund is that investors are able to reduce their operational risks, as these are transferred to custodians or to asset managers and ultimately even to the regulator. However, at the limit, depositaries have unclear obligations and liabilities and their extremities have not really been tested yet and will not until there is an actual blow up. However, in transferring this risk, there is an additional cost, as the duty of care on the service providers is increased.

One of the key focus areas with respect to investing into NewCITS is to understand the investment strategy. Some strategies really won’t work without serious shoehorning and if you do force them to fit, you very often increase the risk of the investment. With futures, for example, trading directly on futures has limited risk, as the counterparty is the exchange. Trading through a derivative to fit into NewCITS, however, means your counterparty is now a single investment bank.

The ongoing development in creating clearer contracts can help define and assign responsibility. For the liability of non-financial risk to be shared effectively between parties in the investment industry value chain, however, they must also bear sufficient capital. This is not yet tackled by regulation, although the most obvious way to mitigate this is to only work with large brand name fund houses that would want to protect their reputation and probably have sufficient capital. The message is that the focus of ODD should probably change in comparison to offshore funds, whereby additional attention should be paid to the contracts between the various service parties.

Managed accounts – another solution?

Managed accounts provide another solution and are available as stand alone vehicles or through platforms. However, the set-up and structure of the managed account varies across the industry. Some platforms provide a full range of services, ranging from ODD on the manager to risk monitoring, stress testing, sophisticated reporting, ongoing monitoring and access to investment analysts. This means that investors only need to select a fund. At this level the investor would need to carry out due diligence on the platform and ensure they have a strong and stable set-up and how or if the underlying funds differ from the flagship fund and what the role is of the various service providers. However, the other end of the spectrum, where the platform is simply a segregated account, allows the investor to control many of the aspects and the platform is purely a transparent investment vehicle. This requires the investor to have considerably more resources and requires him to influence the reporting, understand the underlying investments and more often than not require the investor to bring along a considerable investment sum to make it worthwhile. Clearly, there are differing types of managed accounts and the type of managed account chosen depends on the needs, skill set and capability of the end investor. To a certain extent, depending on the solution chosen, the investor either outsources his ODD to the managed account provider or ODD is fully involved in the set-up in the managed account. The mere fact that the fund exists as a managed account does not mitigate the need for ODD. Indeed managed accounts have also gone wrong in the past, for example where there has been insufficient monitoring of counterparty risks, or if only one prime broker is used. We also do not need to think about the re-hypothecation issues which have recently come to light! There have also been funds that have been liquidated as the flagship fund has committed serious breaches, however the managed account protected ownership of the assets and allowed for a successful winding down of the fund. With managed accounts, again the focus should be on understanding what you are ‘outsourcing’ to the platform provider and what you do yourself and where the control and responsibilities lie. This does not mitigate the need for ODD; it simply requires a change of focus.

Key role of due diligence
A range of investment opportunities are available to hedge fund investors ranging from the traditionaloffshore fund through to managed accounts and NewCITS funds. Lessons learnt recently have brought the requirement for a much heavier form of ODD to be carried out, with the function being regarded as a key investment role and no longer on the periphery. Often the issues raised may not be issues that appear in the long only world and an investor will need to take an informed decision. However, differing investment vehicles and solutions require differing skill sets and knowledge. A larger onus is now placed on the investor to understand what is happening within a fund so that they can use the information to make a sound investment decision.

Marc de Kloe is responsible for alternative investment product management at ABN AMRO Private Banking, responsible globally but based in Amsterdam.