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:
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.
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 Only when the manager mandate can be withdrawn at any time.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
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.