EDHEC-Risk Concept Industry Analysis Featured Analysis Latest EDHEC-Risk Surveys Features Interviews Indexes and Benchmarking FTSE EDHEC-Risk Efficient Index Series FTSE EDHEC-Risk ERAFP SRI Index EDHEC-Risk Alternative Indexes EDHEC IEIF Quarterly Commercial Property Index (France) Hedge Fund Index Research Equity Index Research Amundi "ETF, Indexing and Smart Beta Investment Strategies" Research Chair Rothschild & Cie "Active Allocation to Smart Factor Indices" Research Chair Index Regulation and Transparency ERI Scientific Beta Performance and Risk Reporting Hedge Fund Performance Performance Measurement for Traditional Investment CACEIS "New Frontiers in Risk Assessment and Performance Reporting" Research Chair Asset Allocation and Alternative Diversification Real Assets Meridiam Infrastructure/Campbell Lutyens "Infrastructure Equity Investment Management and Benchmarking" Research Chair Natixis "Investment and Governance Characteristics of Infrastructure Debt Instruments" Research Chair Société Générale Prime Services (Newedge) "Advanced Modelling for Alternative Investments" Research Chair CME Group "Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" Strategic Research Project Asset Allocation and Derivative Instruments Volatility Research Eurex "The Benefits of Volatility Derivatives in Equity Portfolio Management" Strategic Research Project SGCIB "Structured Investment Strategies" Research ALM and Asset Allocation Solutions ALM and Private Wealth Management AXA Investment Managers "Regulation and Institutional Investment" Research Chair BNP Paribas Investment Partners "ALM and Institutional Investment Management" Research Chair Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair Lyxor "Risk Allocation Solutions" Research Chair Merrill Lynch Wealth Management "Risk Allocation Framework for Goal-Driven Investing Strategies" Research Chair Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair Non-Financial Risks, Regulation and Innovations Risk and Regulation in the European Fund Management Industry Index Regulation and Transparency Best Execution: MiFID and TCA Mitigating Hedge Funds Operational Risks FBF "Innovations and Regulations in Investment Banking" Research Chair EDHEC-Risk Publications All EDHEC-Risk Publications EDHEC-Risk Position Papers IPE EDHEC-Risk Institute Research Insights AsianInvestor EDHEC-Risk Institute Research Insights P&I EDHEC-Risk Institute Research for Institutional Money Management Books EDHEC-Risk Newsletter Events Events organised by EDHEC-Risk Institute EDHEC-Risk Smart Beta Day Amsterdam 2017, Amsterdam, 21 November, 2017 EDHEC-Risk Smart Beta Day North America 2017, New York, 6 December, 2017 Events involving EDHEC-Risk Institute's participation EDHEC-Risk Institute Presentation Research Programmes Research Chairs and Strategic and Private Research Projects Partnership International Advisory Board Team EDHEC-Risk News EDHEC-Risk Newsletter EDHEC-Risk Press Releases EDHEC-Risk in the Press Careers EDHEC Risk Institute-Asia EDHEC Business School EDHEC-Risk Executive Education EDHEC-Risk Advances in Asset Allocation Blended Learning Programme 2017-2018 Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management Yale SOM-EDHEC-Risk Harvesting Risk Premia in Alternative Asset Classes and Investment Strategies Seminar, New Haven, 5-7 February, 2018 Investment Management Seminars Contact EDHEC-Risk Executive Education Contact Us ERI Scientific Beta EDHEC PhD in Finance
Non-Financial Risks, Regulation and Innovations

Mitigating Hedge Funds’ Operational Risks: Benefits and limitations of managed account platforms

When accompanied by appropriate risk monitoring and adequate structuring of the relationship with the hedge fund manager, managed accounts today represent a very efficient approach to mitigating operational risks, especially when the size of the investments does not allow for a dedicated operational due diligence and risk monitoring team to be set up.

Operational risk is by far the most complex and intriguing issue investors are dealing with when allocating capital to hedge funds. Due to sophisticated trading strategies, potentially high levels of portfolio turnover, investment in illiquid or difficult to price instruments and a moderately regulated environment, hedge funds tend to exhibit high levels of extreme risks related to non-financial events (fraud and misappropriation, misrepresentation, model risk, infrastructure risk, etc.).

The intention of this paper is to examine the expected benefits and limitations of hosting hedge funds on managed account platforms in order to minimise the level of non-financial risks.

The paper first examines the real extent of operational risks and the various factors that can explain the likelihood of certain funds ending up in situations where non-financial elements result in a collapse or a precipitated winding up. The study identifies governance, specifically the absence of independent oversight, as the most important element to be considered prior to investing in hedge funds, since the majority of accidents can be related to one of the following factors:

  • Position pricing & NAV calculation procedures
  • Client reporting procedures
  • Reconciliation capabilities
  • Compliance controls
  • Risk management infrastructure. The paper then examines the various forms of managed account available to investors, from straight custodial arrangements to advanced managed account platforms offering a wide range of additional services such as independent valuation and risk monitoring.

    Segregated or managed accounts have been designed by investors to achieve a higher level of protection against possible fraudulent activities that could take place within a hedge fund structured around a private partnership.

    Given the wide range of services managed accounts and similar platforms can provide, it remains essential for the investor to clearly understand and verify the nature of the contractual arrangements between the management company and the service provider.

    Table 1: Benefits range from basic segregation of assets to advanced independent risk controls

    1. Only when independent reporting of assets is performed by the custodian bank directly to the investor.
    2. Only when cash instructions are countersigned by the prime broker.
    3. Only when the manager mandate can be withdrawn at any time.
    4. Only when back office services are provided as part of the platform.

    No investor can expect to be fully insured against deliberate fraud or operational risks. It is however very important to stress that a managed account platform accompanied by terms and conditions that allow the risk management team to instantly cease the relationship with the manager and the use of a systematic and independent valuation and risk monitoring function can allow for severe curtailment of several sources of risk, which represent 85% of the hedge fund debacles analysed:

    • Misappropriation: 30% of cases analysed
    • Misrepresentation: 41% of cases analysed
    • Trading outside of OM: 14% of cases analysed
    Managed accounts, when accompanied by appropriate risk monitoring and adequate structuring of the relationship with the hedge fund manager today represent a very efficient approach to mitigating operational risks, especially when the size of the investments does not allow for a dedicated operational due diligence and risk monitoring team to be set up. By clearly containing the most important operational risks hedge fund investors may face, managed account platforms offer a level of protection that significantly reduces the selection risk involved in direct investments in hedge funds, allowing the fund of hedge fund manager, or the final investor, to focus investments and efforts on the asset allocation and manager selection phases of the investment process.

    It becomes the investor’s responsibility to carefully analyse the cost benefits of managed accounts in light of a complete analysis of the expenses related to implementing an infrastructure and investment environment offering similar levels of protection.