Mitigating hedge fund operational risk requires diligent attention

Start-up hedge fund managers are typically small businesses trading complex and illiquid financial instruments.

Pioneers in financial engineering, empowered with broad investment mandates, hedge funds have been known to trade arcane securities and derivatives such as ASCOTs (asset swapped convertible option transactions), CoCos (contingent convertibles), EETCs (enhanced equipment trust certificates), life settlements, and credit default swaptions.

Separately, while the individuals running these firms might have accumulated a stellar track record in terms of investment performance, they may have little to no experience running a business, having likely worked under the umbrella of large financial institutions with significant resources. Segregation of duties between the front office, back office and compliance functions is of crucial importance in a hedge fund, much like in any asset management firm.

While much has changed in the last few years through institutionalization of processes and advancements in technology, investing in hedge funds, like other investment structures, still carries a level of investment and operational risk. The objective of this article is to explain operational risk, show the evolution of operational due diligence (ODD) and demonstrate the importance of ODD in the manager selection process. We also explore two key areas of a typical ODD review.

Defining operational risk

Stemming from many sources, operational or non-investment risk has been defined by The Basel Committee on Banking Supervision as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” Therefore, operational risk can be qualified as both internal and external to the firm.

While much has changed in the last few years through institutionalization of processes and advancements in technology, investing in hedge funds, like other investment structures, still carries a level of investment and operational risk.

Internal risks include business risk, system risk and valuation risk, while external risks encompass service provider risk, counterparty risk, regulatory risk and reputational or headline risk.Investors can never completely inoculate themselves from operational risk. However understanding, mitigating and monitoring the source of such risks is key to a successful ODD program.

Operational risk failure

ODD gained prominence over the years following some catastrophic operational failures among hedge funds, including Bayou, Lancer, Lipper, Amaranth and Long-Term Capital Management, culminating with the Bernard Madoff Ponzi scheme in 2008. Historically, research1 has shown that the most common causes of operational failure were “theft and asset misappropriation”, followed by “existence of assets” where the manager owns bogus securities, i.e., reported assets do not exist and redemptions are funded with subscriptions. Surprisingly perhaps, the most common hedge fund strategies vulnerable to operational failure are long/short equity followed by managed futures.

Traditionally, investors have viewed holding largely liquid, exchange-traded securities as straightforward with low operational risk, but this clearly isn’t the case. A 2003 Capco Institute study of hedge fund blow-ups found that 50% of hedge fund failures occurred because of operational issues and 6% failed due to business issues—compared to 38% that failed because of investment risks2. Despite the well-publicized and, at times, spectacular failures, fraud is not widespread across the hedge fund industry and these cases are still relatively rare.

Traditionally, investors have viewed holding largely liquid, exchange-traded securities as straightforward with low operational risk, but this clearly isn’t the case.

The Madoff crisis pushed operational risk front and center for institutional investors who were previously reluctant to embrace the benefits of ODD due to high costs. Today, ODD is an integral and necessary part of the manager selection process.

Where does ODD fit into the selection process?

The evaluation of a hedge fund involves two main areas: investment due diligence and ODD. While there is some overlap, the objective of investment due diligence is to determine whether or not the firm has a sustainable edge within its strategy. This is accomplished by reviewing the investment team, process and track record. In comparison, for the operational component, the objective is to evaluate, irrespective of performance, whether a hedge fund manager has taken adequate steps to mitigate operational risks surrounding its business, the management of its funds and whether the funds are subject to appropriate external oversight.

 

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1 Castle Hall Alternatives , From Manhattan to Madoff: The Causes and Lessons of Hedge Fund Operational Failure 2009. Retrieved from: http://www.opalesque.com/files/ManhattantoMadoff.pdf

2 Feffer. S., and C. Kundro, 2003, ‘Understanding and mitigating operational risk in hedge fund investing,’ white paper series, Capco Institute, March 2003.