But just having independent and experienced directors on board is not the whole picture. Directors have to be empowered with the ability to step in when necessary. “If an independent board member is appointed by the manager that manager can get rid of him at any time so his teeth are blunted, but if he is appointed by the managed account platform they are clearly working for the investor not the manager,” says Sciens Capital’s Godden.
For example, when it comes to deciding actions such as suspending redemptions that decision should be made by the board of directors and if that board is not independent the decision is effectively down to the investment manager. A conflict of interest can ensue when on one hand the manager wants to keep its assets under management as high as possible but on the other it is meant to do what is in the best interests of investors. It is therefore advantageous for the board to be truly independent.
However, according to Throgmorton’s Rubio, having this independence might come at a cost to investors as it is more expensive to appoint quality independent directors – a cost which ultimately lands with the end investor because it goes against the performance of the fund.
“You are talking about quadrupling the amount of money paid to these people so it is a significant uptick,” he says. However, he adds: “I think investors are more than happy to pick this up to avoid any occurrence of massive losses or fraudulent activity.”
Directing the action
Another way to achieve heightened governance and transparency in hedge funds is through accessing them via managed account platforms which have increased in popularity in recent years. According to Godden, at the beginning of 2011 the amount invested in hedge funds via managed accounts was less than $100bn but that has grown to about $280bn currently.
Dutch schemes PGGM, the administrator for pension schemes in the care and welfare sector, and ABP, the pension fund for government and education employees, both access hedge funds via managed account platforms, as do the California Public Employees’ Retirement System in the US and the UK’s Universities Superannuation Scheme. Elsewhere, Godden says a number of hedge funds of funds are also migrating to managed account platforms.
Under a managed account platform, rather than leaving the decisions solely to the investment manager an investor uses a segregated managed account run by a third party, or itself if it is large enough to have established one. The platform operator makes the decisions including appointing the administrator, the trading entities and the board of directors and the manager merely advises on what to buy and sell either through some sort of discretionary device or a systematic signal generator.
The platform provider liaises directly with the broker who puts the trades on and ensures on a daily basis that the manager sticks within investment limitations. The provider is able to see the positions a manager has directly from the brokers not the manager themselves and if that position is breached it has the power to push it back under the limit.
“Madoff could never have happened on a managed account platform because they see every trade and the information from those trades are not sourced from the managers but from the people doing the deals,” says Godden.
However, one of the disadvantages of managed account platforms according to Momentum Global Investment Management head of alternative strategies John Caulfield is you sometimes have restricted access to some of the more esoteric, less liquid strategies.
A leading role
Investors can have sway and persuade hedge fund managers to change their board composition if they do not agree with it – something Momentum’s Caulfield encourages investors to do. He explains a lot of managers when they launch hedge funds come from a proprietary trading environment where everything is done for them and subsequently rely on their providers to advise them on what best practice is and most of them actually welcome the input.
“Most hedge fund guys are businessmen and want to go about it in an intelligent way, so if you make suggestions 99 out of 100 times they will make the changes,” says Caulfield. “We have got funds to change their terms on a number of occasions. We have to have an independent board and if they don’t have that, it is a non starter.”
Ultimately, it is the end investor who loses out to this type of fraud and Rubio believes the end investors should meet face-to-face with the directors of the funds and interview them. “I think there should be more of that so they can satisfy themselves that the person who directs the fund has substance and is credible,” he says.
Caulfield adds: “If someone has no experience in investing in hedge funds my recommendation would be to find a qualified intermediary who has managed money through 2008 and who can give examples of managers who have failed due diligence tests. If you have an audited track record through 2008 it is pretty easy to see if their rhetoric is backed up by their numbers.
“They [investors] are the ones writing the cheques at the end of the day and there are plenty of funds out there, so if you come across a fund that has had good returns but there are operational issues you have to let them know – that could be a deal breaker.”
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