There is, however, no easy number by which to measure operational risk, no universally recognised minimum standard or best practice. Investors therefore have to establish their own standards and carry out sufficient analysis on each manager to ensure they only select those that conform to their standards. Because of the qualitative, but critical, nature of this task, there can be no substitute for experience and knowledge of the industry.
As MGIM portfolio manager David Lashbrook says: “Operational risk is definitely an enormously important factor in hedge fund investment and comes down to experience. This is a key part of funds of funds value proposition.”
Operational due diligence
Furthermore, operational due diligence needs to be regularly conducted. Gone are the days of conducting one process at the initial allocation stage. Experiences in 2008 and 2011 taught investors the impact that ongoing factors, such as the availability of leverage and financing arrangements, can have on the operational risk profile of a hedge fund. Changes in administrator or personnel can also prove critical.
What that means is a huge time and resource commitment for institutions looking invest directly. “Below an allocation of $500m to hedge funds, it is probably extremely challenging to do everything internally to avoid problems caused by operational risk such as blow-ups,” Lyxor’s Erdely says. “Investors have not placed enough value in the operational due diligence process,” he continues. “Operational risk can never be measured in figures, but you know one day it will cost you money. Funds that don’t pass our on-going operational due diligence are simply not part of our investment universe. The only other way to reflect that factor is by being penalising in the risk budget allocated to a manager. It takes a lot of effort and talent to construct a robust portfolio that is in line with investors’ risk parameters and investment objectives and to quickly respond to changes in underlying managers’ risk profiles as they occur.”
Even investing directly with large, established managers is no panacea for getting around operational risk as history has repeatedly proven.
Amaranth Advisors, a $9bn multi-strategy fund, famously blew up in 2006 after operational failings allowed Brian Hunter to make a hugely concentrated bet on natural gas, which lost the fund $6.5bn. Hunter was later found to have intentionally manipulated natural gas futures prices. Bernie Madoff , perhaps the most notorious of all hedge fund blow-ups, perpetrated a $65bn fraud in 2009.
A considerable number of Ponzi schemes have since blown-up. More recently, $600m Weavering Capital collapsed following revelations the fund’s assets consisted mainly of huge swap transactions with companies controlled by Weavering’s founder Magnus Peterson, the fi rst major fraud in the UK. Meanwhile the SEC has fi led charges against Philip Falcone and his firm, Harbinger Capital Partners, whose AUM reportedly peaked as high as $26bn, of civil fraud for using money to pay his taxes and favouring some fund customers at the expense of others.
The list of operational failings at hedge funds continues to expand at a staggering rate, adding ever more weight to the importance of conducting thorough and regular due diligence on hedge funds.
“It takes a huge, dedicated team to review and confirm all aspects of hedge funds’ operations,” says Scott Schweighauser, chief investment officer at Aurora Investment Management. “The resources needed to perform that task in a responsible fiduciary way are pretty substantial. Most institutions don’t have those resources.”
The scale of the operational due diligence task appears to be dawning on investors. Some of those who moved away from funds of funds in favour of the direct approach have since returned. Ederly believes many institutional investors have underestimated the level of resources necessary to fully analyse hedge funds.
“As a result, some clients that have tried direct investment, have subsequently come back,” he says.
The world of hedge fund investing remains a complex business where it is easy to focus on performance and underestimate the importance of other risk factors such as operational failings. That is where a good, institutional quality fund of funds can still add value given the reliance on experience and dedicated resources of conducting thorough and regular due diligence. As such, funds of funds that can prove their prowess should remain firmly on investors’ radar.
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