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Risk - January 18, 2006

Interview with Jean-René Giraud, CEO of Edhec-Risk Advisory

In this month's interview, Jean-René Giraud, CEO of Edhec-Risk Advisory, talks to us about financial and operational risks in the area of hedge funds and also about Edhec-Risk Advisory's plans for 2006.

Jean-René Giraud

What has Edhec's research shown on the relative importance of financial risks and operational risks in the area of hedge funds?

Jean-René Giraud: Hedge funds are one of the most interesting asset classes when it comes to diversifying the financial risks of a private or institutional portfolio invested in bonds or equities. The benefits of hedge funds in improving the risk/return profile of a portfolio have been persistently demonstrated in a significant number of studies, amongst which Edhec has contributed a certain number.

Like any form of investment, such as direct investment in shares, private equity or even bonds, investors are not totally immune from the risk of monies being swept away in a troubled fund. Hedge fund defaults do happen at a pace than cannot be considered negligible, with 15 publicly disclosed hedge fund failures every year out of a universe comprising between 7,000 and 10,000 funds, the rate of default is far from zero.

More important is the fact that more than 60% of hedge fund failures can be directly related to operational issues that have nothing to do with the financial performances and risks of the investment. With two-thirds of these operational failures being directly related to different forms of fraud (misappropriation, misrepresentation, trading outside of the mandate guidelines), the risks carried by the investor involve more than the direct financial exposure alone, and have a significant reputation aspect.

When analysing hedge fund failures over the past twenty years, it is interesting to note that in a large majority of situations, fraudulent or not, weak operational controls, infrastructure and inappropriate fund governance and oversight have allowed, though not directly caused, the collapse of the fund.

It is the investor’s responsibility, either directly, with the help of an investment consultant, or through the remit of a fund of hedge funds, to assess the organisation managing the assets and ensure that such extreme situations are prevented through appropriate controls and reviews.

Sadly for the investor, and unlike financial risks, operational risk does not come with a premium. Lack of consideration of these risks therefore translates into a direct loss for the investor and it would be wrong to think that one cannot address the question in an economically interesting way.

What are the advantages and disadvantages of managed accounts compared to the other means of investing in hedge funds?

Jean-René Giraud: With a mere 27% of hedge funds still providing prices to the administrator for NAV purposes, 36% of the funds overriding prices provided by the administrator, and self-administration being the norm in a significant number of fraudulent schemes, the question of independent valuation and control should be very high on investors’ agendas.

Managed accounts represent one of the most promising routes offered to investors in mitigating operational risks. By separating the custody of the assets from the manager and ensuring that independent control of the investment process and the valuation of the funds is in place, our study shows that up to 85% of the situations studied could have been prevented.

However, one should be careful and avoid falling into the marketing pitfalls that overly aggressive managers might fall into by labelling their fund ‘risk free’ thanks to a managed account structure, or a highly respected prime broker’s name on the brochure. As is very often the case, there is nothing more different from a managed account than another managed account, and the devil is in the details of the actual services part of the deal offered by the bank holding the account.

From basic custody and prime brokerage to advanced risk monitoring and total segregation of assets from the hands of managers, managed accounts come in a wide range of flavours that offer different levels of protection to the investor. Understanding what risks are mitigated by the managed account structure and what risks are not is the key element when selecting a service provider.

Awareness of the true service offered remains key, as managed accounts do come at a price, a price that is considered too high by some, but that remains in fact reasonable when compared to the costs the investor would bear if he had to support the full cost of the extensive due diligence and overall monitoring required to mitigate the operational risks involved in a direct investment in hedge funds.

Are there other ways in which investors can mitigate operational risks?

Jean-René Giraud: Advanced managed accounts represent the most sophisticated approach to investing in hedge funds and are the result of increasing awareness of the real risks involved. It is also a straightforward way for investors to access a platform that benefits from years of experience and allows costs to be shared across a large number of investors.

As we found out in previous studies published by Edhec in 2003, systematic operational due diligence and permanent monitoring of the fund do allow a very significant part of the operational risks of hedge funds to be mitigated. At the very least, they allow the investor to have a better understanding of the operational and governance weaknesses of a structure, information that can be factored into the investment process as part of a well-informed diversification strategy.

But once again, the cost of operational due diligence, which is very often seriously underestimated by small and medium-size funds of hedge funds, remains very high and can only be justified for significant investments or large organisations handling investments for a large number of investors. Moreover, implementing a thorough and systematic due diligence process is an art that few have proven to be able to perform, not so much for a question of skill, but merely because of the intrinsic complexity of the task.

What are the difficulties that investors are liable to encounter when carrying out due diligence?

Jean-René Giraud: Operational due diligence is rendered extremely difficult and its output is unlikely to be totally satisfying for three reasons.

First, assessing the operational solidity of a firm is a complex analysis that involves a very large number of orthogonal areas that a single analyst is unlikely to master. Technology, operations and back office, trading, regulations, accounting and valuation are some of the most significant areas to be investigated. A top hedge fund analyst with expertise in all these areas is a rare bird indeed.

Secondly, hedge funds tend to refrain from opening their doors and keep themselves well protected behind the ‘trading secret’ barrier. Even if a trend of increased transparency is currently underway, investors should never forget that, while carrying out due diligence, they are in fact being ‘sold’ the fund. The interest for the manager in showing a perfect world is too high to allow for external analysts, often more junior than the people they meet, to spot the hidden issues.

Finally, even though most firms repeat due diligence on a regular basis, due diligence usually takes place before problems occur. Evidence shows that in most situations, fraudulent situations develop on the back of small losses and nothing prevents managers from changing the way they operate (dealing in OTC markets not initially allowed, changing prime broker, changing administrator, etc.) in between two visits or yearly audits. Due diligence allows for ex-ante assessment but does not constrain the hedge fund to operate in an environment that has been assessed and approved as safe by the investor.

You are the CEO of Edhec-Risk Advisory, the consultancy arm of the Edhec Risk and Asset Management Research Centre. Could you tell us a bit about Edhec-Risk Advisory's activities and your plans for 2006?

Jean-René Giraud: 2005 was a year of development of the advisory activity in the UK. With significant new clients on board such as MAN Financial, Credit Suisse Group, Citigroup and Euronext Liffe, Edhec-Risk Advisory has established itself as one of the most credible providers of expertise in the areas of operations and risk management.

Lessons learned in the alternative investment industry have allowed us to develop our presence both in the buy-side and sell-side arenas on a number of projects, either as part of a strategic move or as part of the ongoing improvement of client services.

Apart from our development in the operations and risk areas, 2005 also saw the emergence of a significant activity in the trading space on the back of the intense regulatory activity affecting European Capital Markets. MiFID (Markets in Financial Instruments Directive) is considered to be one of the main drivers of a re-invention of the industry, with exchanges and banks entering an open competition landscape and considerable harmonisation across countries and asset classes. MiFID is likely to be the most drastic change in our markets ever, impacting the competitive landscape and allowing for significant improvements to occur, but maintaining significant strain on existing players.