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Operational Risk
Mitigating Hedge Funds’ Operational Risks: Benefits and limitations of managed account platforms
Authors: Jean-René Giraud
Source: Working Paper, Edhec Risk and Asset Management Research Centre
Date: 2005
Size: 798919 Bytes

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 can possibly 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.

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 operating mandate: 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.

This study was initially developed to support Edhec’s decision to collaborate with managed account providers in order to develop investable indices replicating the now widely adopted indices of indices (available on www.edhec-risk.com). The outcome of the study convinced the Edhec Risk and Asset Management Research Centre that the benefits of managed account platforms clearly outweigh their cost and limitations, provided the infrastructure allows for the implementation of a systematic approach to measuring and managing financial risks and that the design of the platform allows for most operational risk factors to be substantially mitigated. As a direct consequence of this study, the Edhec Risk and Asset Management Research Centre selected Lyxor, part of Société Générale Group, as a strategic partner for the creation of its Hedge Fund Equity and Bond Diversifier Benchmarks. These are constructed with elementary components, the “investable indices”, which are implemented with a selection of hedge funds available on the platform.

This study has since been revisited and expanded to cover all aspects of operational risk mitigation with managed account platforms.