survey tells investors to change due diligence focus to back office process as much as investment strategy
An alarmingly high number of hedge funds fail because of operational issues rather than investment risk, according to a recent hedge fund study.
Carried out by financial services consultancy Capco, the study of 100 hedge fund failures over the past 20 years found 50% come from operational risk rather than bad investment decisions.
The finding has important implications for investor due diligence, which has traditionally focused on management, suggesting an equal weighting should be put on back-office systems.
There are around 6,000 hedge funds worldwide with an estimated E600bn in assets under management. Last year, 700 hedge funds closed and this year 800 closures are predicted, according to hedge fund consultants Tremont Advisers.
Most hedge fund investors focus on the investment side ' including management, strategy and track records ' and pay little attention to the operational side of the businesses they are giving their money to.
This is a mistake, according to the survey's findings. From the sample of failures analysed, the most common operational issues related to hedge fund losses were misrepresentation of fund investments, misappropriation of funds, unauthorised trading, and inadequate resources. The first three of these were present to some degree in 85% of cases and only 38% of the hedge fund failures were due to investment risk alone.
While it is impossible to properly predict if a manager will commit fraud, the survey advises investors to understand to what extent the opportunity exists to manipulate and misrepresent fund investments should their managers feel the urge.
'This can be accomplished through a complete scrutiny of a hedge fund's operations and technology capabilities and a detailed understanding of the information flows between a fund and its supporting service providers that typically include prime brokers and administrators,' the survey says.
Relying on a fund's administrators and auditors for information may not be enough, it adds. 'For example, to hide substantial investment losses, the Manhattan fund allegedly created fictitious account statements that materially overstated the value of the fund. These statements were provided to investors, potential investors as well as the funds' administrator and auditor for more than three years with neither the administrator nor the auditor catching the problem.'
Capco defines five key characteristics for hedge fund due diligence. They include the hedge fund supplying a comprehensive view of the structure, quality and control of the people, operations, technology and data supporting the fund, and cover the processes, systems and information flows used by the fund as well as by external parties including prime brokers, administrators and custodians. They also include analysis of the unique requirement of each strategy and all of this should be updated on a periodic and event-driven basis.
With the hedge fund industry expected to continue growing, Capco predicts an increase in operational and performance demands as new managers enter the field, the complexity of strategies expands and more regulations are adopted.
'All of this suggests the operational risks associated with these investments will only grow more important,' the study concludes. 'For the hedge fund investor, effective operational due diligence and monitoring will be key to reducing the potential of catastrophic losses and improving long-term investment results in this sector.'
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