Managing hedge funds' operational risks

By their very nature, hedge funds allow investors to be exposed to different risk factors including volatility, counterparty, or liquidity risk, since this exposure is considered a source of superior returns for invested funds.

Market makers receive a premium (the spread) when acting as liquidity providers in a market. When hedge funds implement trading strategies that provide liquidity to a market, part of the return that can be expected is a premium for the liquidity risk they carry when holding illiquid instruments potentially subject to price swings.

Exposure to these risk factors is not only a source of superior return but also the very essence of hedge funds' extensive diversification possibilities compared with traditional investments.1 Exposure to these risk factors is also a diversifiable risk, as it has been demonstrated hedge funds exhibit low correlations among themselves.2

These advantages do not come without downside. Gaining exposure to alternative risk factors usually requires trading activities that can be considered less conventional than in long-only.

These include investments in illiquid instruments, extremely high portfolio turnovers and non-vanilla over-the-counter contracts. While these technicalities do not themselves represent an issue, they do, however, carry a level of operational risk for which no premium is paid.

It is interesting to note that hedge reporting on hedge fund risk exposure focuses on financial risks only, when it is not limited to market risk. Recent studies such as Capco's3 show interesting results on the importance of non-financial risks.

A key finding is that operational risk greatly exceeds risk related to investment strategy, with at least 56% of the hedge fund collapses (that is, funds that have ceased operations with or without returning capital to shareholders) directly related to a failure of one or several operational processes.

With an average of only 15 fund collapses annually4 out of a few thousand funds open to investment, it becomes clear risks related to hedge funds' operational weaknesses significantly outweigh levels of financial risk, which are usually the focus of the managers' attention.

Assuming the universe of investable funds is 2500, failure rate can be estimated at 0.6%, representing a very high probability of default in the context of funds of hedge funds investing in 10 to 25 vehicles.

Analysing historical data on hedge fund failures is rendered extremely difficult by lack of transparency on the chain of events leading to bankruptcy or closure. Not only is information not always publicly available (as investors may choose private settlement to exit a difficult situation) when information is available, it is usually in a very controversial and even passionate debate.

Table 1 on page 32 shows cases with very high-level interpretation of what might have caused the failure.

In eight of 10 cases (excepting Tiger Management and Everest), operational weaknesses are the root cause of failure or have prevented a fund from managing a crisis situation appropriately in an unexpected financial context.

While few funds fail purely because of an operational problem, a weak operational environment will increase the impact of an external event. While fraud is rarely a manager's initial intention, the complexity of the support infrastructure inherent in trading activity, as well as lack of industry maturity, provide many opportunities for operational risks only mitigated by an appropriate and professional due diligence process on the investment pools.

While misappropriation, misrepresentation and deliberate fraud constitute main sources of operational issues explaining hedge fund failures,5 these issues are only made possible by the limited regulatory constraints hedge funds face and the lack of maturity of the industry with regard to operational practices, especially in relation to position pricing and NAV calculation procedures, client-reporting procedures, reconciliation capabilities, compliance controls, risk management infrastructure.

Hedge funds' relative operational weaknesses have been analysed and show the importance of compliance controls; pricing and NAV; and client reporting, as the operational failures' three main sources.

Analysis confirms the importance of adequate operational due diligence before hedge fund investment and the need for formal procedures to ascertain levels of operational risk to construct an optimal hedge fund portfolio.

Transparency

Full transparency and managed accounts are cited as key to providing higher levels of security with hedge fund investments. This does not correspond to the reality of funds of hedge funds (FoHF), as 79% of funds responding to the Edhec European Alternative Multi-management Survey do not require their target hedge funds to segregate assets in a managed account.6

Managed accounts might seem to solve important issues raised by investors, for example:

•With a managed account structure, assets are effectively physically separated from the management company, reducing the level of risks related to fund misappropriation;

•As the managed account comprises all assets allocated to the fund manager, reporting on the actual valuation of these assets cannot be biased through false reports from the manager. Strictly speaking, the administrator can value the funds independently without manager interference;

•With a daily snapshot of open positions, the FoHFs can effectively monitor implementation of fund strategy and its direct results, offering early redemptions when investors are not keen to follow that investment strategy.

However, do not overestimate these benefits. Costs of monitoring a series of managed accounts are extremely high, and so only available for large FoHFs.

Structured derivatives and other complex financial instruments can allow the manager to divert capital from the fund to offshore accounts without being seen as anything other than investing in a losing strategy.

Transparent daily reporting is nice in theory but reaches its limitations when the staff in charge of monitoring the hedge funds have to validate sometimes thousands of open positions, very often in totally illiquid instruments where valuation may even come down to the responsibility of the manager as the independent administrator might be caught in a situation where the only available source for price is the front office.

Interfering with the day-to-day management of the assets might prove dangerous and not in line with the expectations of the final investors. Understanding complex trading strategies of 30 underlying funds can prove so difficult that the FoHF may redeem, which may be inconsistent with its initial allocation strategy.

If ensuring appropriate controls are in place to make certain the hedge fund manager will only operate in the best interest of his client, full daily position transparency will not provide the level of guarantee required to justify the infrastructure, team and costs.

Liquidity risk

While issues from lack of liquidity in the instruments hedge funds trade are most widely discussed, financing liquidity and the asset-liability mismatch should be considered more important for FoHF managers.

Hedge funds rely on prime brokers and banks to obtain financing for leverage or bridging cash positions. These lines of credit are highly dependent upon market conditions, and contractual agreements are usually such that the prime broker can substantially increase the haircut or amount available.

The manager may therefore have to liquidate at a loss or in unfavourable market conditions. Individual managers and FoHF managers using external financing should monitor sensitivity to providers' haircut changes.

This problem does not disappear with FoHFs. While the theoretical level of liquidity of the underlying investments is known in advance, fund of hedge funds managers, to successfully manage the liquidity of his vehicle, will consider redemption periods and payment conditions for each underlying fund, subscription/redemption periods applicable to his own fund, as well as its cash position and implications of any redemption on the allocation to the various funds.

Funds of hedge funds can maintain a buffer of uninvested capital allowing transition periods to be managed. This results in lower hedge fund exposure. Bridging loans usually come at a high cost, but give sufficient flexibility, provided they are negotiated in firm terms before liquidity events occur.

In light of the numerous quantitative issues related to the analysis of historical fund performance and proper isolation of the alpha from the premiums related to residual risk factors, one might question the real value added of FoHFs within the fund selection process.

Investors usually turn to FoHFs for one of three main reasons: access to investment capacity to funds no longer open to new investors; better fund selection by the FoHFs manager and better risk management capabilities.

While access to investment capacity and fund selection are usually the selling points for FoHFs, the complexity of managing risk may remain an issue for small to medium-sized FoHFs. The risk management function encompasses a series of responsibilities before and after the investment decision. These cover the whole spectrum of risks, from the financial risks associated with the various investment strategies to the no-less-important operational risk factors resulting from the highly complex nature of hedge fund trading activity.

It is therefore not surprising to see that 33% of FoHF managers have decided to sub-contract partially or entirely the due diligence process, which represents the most challenging task for risk managers (see graph 4).

If selecting the funds that will perform best is a difficult goal, avoiding allocating assets to future losers cannot be considered a 'no-brainer'. For some FoHFs, performing due diligence on a hedge fund is sometimes still synonymous with performing a background check on the manager and the company and then spending a few hours discussing the investment strategy and the supporting infrastructure with a representative of the fund.

We have seen that this approach will not provide any sense of the reality of the investment's extreme risks, as the due diligence takes place in the middle of a sales relationship where the hedge fund is selling its capacity rather than openly discussing strengths and weaknesses. Instead, we will see that a structured process needs to be implemented that assesses a series of risk indicators, if possible in a systematic, repeatable and numerical approach to allow for the inclusion of the results within an allocation model.

It is interesting to note that while most FoHF respondents cite the quality of risk monitoring and reporting, verification of historical fund performance and the reliability of the position-evaluation process as being vital, the reputation of the key service provider is still considered an important factor. With regard to risk management functions, FoHFs attach very high importance to the capacity of the underlying funds to implement risk controls (quality of risk monitoring and reporting, organisation and reliability of the position evaluation process) as they are not themselves in control of these processes (see Table 2, right)7.

This finding may be explained by the fact that only two FoHFs of three have a specific department in charge of risk management (average: 3.7 staff members involved), leaving 33% of the funds without any control on the levels of risks the investor is exposed to (see graph 5)8.

Hedge funds are investments exhibiting interesting financial properties, justifying exposure to higher levels of operational risks. The appropriate approach cannot be to attempt to reduce these risks inherent to the trading strategies and legal framework, allowing the hedge fund market to develop. One should ensure investors can assess independently the level of operational risks, diversify it adequately and ensure proper risk mitigation measures are implemented.

While FoHFs will remain the predominant vehicle for institutional investment, more systematic and repeatable due diligence processes and more appropriate risk management infrastructure will have to be developed.

key points

Operational risk greatly exceeds risk related to investment strategy, with at least 56% of hedge fund collapses directly related to a failure of one or several operational processes.

While few funds fail purely because of an operational problem, a weak operational environment will increase the impact of an external event.

Investors should be able to assess independently levels of operational risks, diversify it adequately and ensure proper risk mitigation measures are implemented.