Predictably, the attention has now turned towards the hedge fund industry. Largely this is due to historical perceptions of the industry as being shrouded in secrecy, with enormous personal gains for practitioners. Whilst the overall investment management industry needs to look at investor needs for further transparency and information sharing, it is essential that the hedge fund industry does too. This is likely to result in changes to ensure that hedge funds remain an important asset class in investment allocations and continue to make a useful contribution to the modern financial system. Given that alternative asset management as a brand is in danger of being tarnished beyond repair, it maybe time to apply a grass roots approach to redefining the industry as we know it today.
Like the current MP expenses scandal rocking Britain’s Parliament, it has taken a massive market shock to highlight shortcomings in hedge fund transparency. The sharp fall in asset prices and subsequent investment performance, coupled with intense scrutiny post-Madoff (and many other smaller frauds), has highlighted the need for hedge funds to address the soaring demands of investors for more clarity and understanding of what they have really invested in and whether these investments fall within guidelines. Both institutional and private investors are challenging hedge funds over failings with the most basic levels of due diligence along with heightened media coverage of the lavish lifestyles of some fund managers.
Obviously it is important to get the context right. Hedge fund performance may have been somewhat lacklustre over a number of sustained periods, but it is wrong to blame the hedge fund industry for the condition of financial markets. Yet the industry, while certainly not absolved of responsibility, has a brand problem that means it must carefully address four keys facts. First, what does it mean to be called a hedge fund and does this brand need to be changed? Second, what structures can be put in place to give investors more asset protection and better transparency? Third, what does it mean to be transparent and what measures can the hedge fund industry put in place to alleviate concerns over transparency, whilst protecting their franchise and the need to keep trading strategies and market positions confidential? And, finally, how do managers put in place client retention strategies to ensure that clients remain focussed on longer term investment returns? Let’s consider each of these fours points briefly.
The hedge fund brand
It is time for the hedge fund industry to look at how it positions itself in the investment industry. Does hedge mean being able to go short? Perhaps it used to, but is this not an old fashioned connotation that misses the point? The most successful investment management firms are the ones that have created investment management platforms with pools of investment and stock picking talent across a range of strategies. Often, such firms blend the merits of a traditional investment model with those of the previously more niche hedge model. As investment platforms further converge, so does regulation. It is inevitable that individual regulators and international cooperation with these regulators will continue to harmonise reporting frameworks across hedge funds and traditional funds.
Investment structures and administration
A recent trend among fund promoters is to offer managed account type structures. Though different forms of such structures co-exist, the general idea is that these vehicles facilitate improved liquidity management, greater transparency and protection of client assets. Such structures will undoubtedly continue to be popular, and the challenge for the industry is how to manage their running costs within an environment of dwindling fee structures.
Another structural trend we see is the adoption of third party administration with daily pricing. The European hedge fund sector has long employed third party administration where the manager uses a third party for pricing and other fiduciary responsibilities. Many US firms, however, are self-administered (Madoff being a notable one) and use monthly pricing – practices the industry has been comfortable with. Notwithstanding difficulties posed by illiquid investments and complex pricing needs, a trend towards mandatory third party administration and daily pricing will surely continue to contribute to the overall health of the hedge fund industry.
Transparency
The whole notion of transparency needs very careful consideration. The immediate reaction to calls for transparency is to provide full disclosure and reams of analysis on every single move a manager makes. Clearly this is not helpful: it will inevitably lead to information overload and asymmetry in decision-making. Remember, looking directly into the sun leads to blindness. Also, with heightened emotions and investors still nursing significant losses, it is important that we don’t overreact and instil practices that are expensive, inefficient and largely unused in more normally functioning markets. The transparency problem can be solved in a practical way by managers and regulators alike taking more individual responsibility.
Regulators should take a measured approach to applying further scrutiny to managers. For example, they should consider having enhanced but moderate rules for disclosure in well-behaved markets but have the necessary authority to apply more stringent measures when markets show signs of dysfunctional behaviour or irrationality. Managers should consider providing more see-through disclosure to investors on positions and trading practices. They should, for example, take advantage of technology and provide investors with secure areas where aggregated positions and context to trading strategies can be provided. This does not mean going so deeply into trading books that any trading advantage could be lost. Rather, it simply requires providing a degree of information to build trust over time. Managers could also delay the release of such information. It is the practice of disclosure that will engender client trust and if this practice becomes habitual investor appreciation of the need for trading privacy will grow.
Client retention
Difficulty with client retention has been one of the most damaging issues emanating from the market crisis. Mass redemptions and herd like behaviour caused untold stress to fund liquidity and played a large role in some funds instigating orderly wind-downs of significantly sized operations. This was compounded with mass redemptions by institutional investors in funds of hedge funds which, in turn, were forced to redeem their underlying investments. The extent of this meant some funds were forced to install gate clauses that suspended further redemptions. The contagion that spread further stigmatised the industry.
Many firms are looking to strengthen their client retention strategies and rely on much more process driven approaches to client management to augment traditional relationship-driven techniques. Client reporting is one such process where hedge funds can demonstrate their commitment to clients and their focus on instilling controlled and measurable operational practices in the key middle offices areas, such as risk management.
This will be in addition to existing improvements over transparency of positions and trading strategies. On this basis, we see hedge funds looking more closely at their middle office operations and perhaps seeking to partner with an emerging band of service providers who can provide them with a controlled business process to ensure client and regulatory reporting are, for example, provisioned from common data sources. Such reporting will begin to include operations updates where clients can see how a hedge fund’s operations are performing against documented benchmarks. Also, hedge funds will seek to use electronic media to ensure clients feel connected to the manager and the funds. We can thus look forward to more informed websites, additional fund manager interviews and the use of other traditional fund management communication tools. Given its nature, however, the hedge fund industry will demand greater protection over the information reported and tighter control over the distribution of any such material.
Conclusion
Hedge funds are being required to change. This coincides with a time when investor anxiety is high, regulatory pressure is intense and markets are beginning to show some (very early and disputed) signs of recovery. The industry can come back stronger than ever, with a loyal and informed investor base, as long as it realises that the message needs to be modified with some strong overtures about how managers are willing to include their clients in the on-going investment process and ensure they do not feel that their money will disappear down a deep, mysterious hole.
Similarly, regulators have their part to play. Their retort to growing pressure from the investment community needs to be measured. But in doing this regulators must adjust rather than transform how hedge funds operate, so that alternative investment managers can continue to serve and contribute to an efficient global financial system.
ABOUT THE AUTHOR
Mash Patel co-founded Kurtosys in 2002. It provides client reporting and information management solutions for the financial services industry from offices in New York and London to customers in the US, UK, Switzerland, South Africa and Australia. The company’s solutions range from data aggregation to final reporting and data distribution.