The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

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Trust and transparency in the US hedge fund sector

By Mike Greenstein, Partner


Q3 2012

Q3 edition



The US hedge fund industry is an integral part of capital markets, yet it has matured in a different way than the broader asset management industry. While its investment processes are highly developed, its governance and operations are less so. In the past few years, hedge funds have reacted to the institutionalization of their investor base, and increasing regulation, by enhancing infrastructure and further aligning interests with investors, in an evolution PwC describes as ‘from black box to open book’. A ‘trust and transparency’ framework is gradually emerging, but it needs to be completed before the industry earns the trust needed to fulfill its long-term growth potential.

In order to understand the measures that hedge fund managers need to take to meet institutional investors’ expectations for transparency, governance and operations, PwC interviewed senior executives from leading US hedge fund managers, investors, and other industry participants (see full report at We found an industry that has made significant improvements in the four years since the financial crisis.

“2008 changed the sector significantly,” says Todd Groome, Chairman of the Alternative Investment Management Association (AIMA) and a principal in Breton Hill Capital. “These changes have included both new regulatory requirements and increased demands from institutional investors. Since the early 2000s, we’ve seen increased institutional investor capital flows into hedge funds, and with this capital has come the increasing institutionalization of hedge fund operations and infrastructure. Following 2008, a much greater investor focus on liquidity, portfolio transparency, control and fund governance was clearly evident. Maybe more than most regulatory changes, the institutionalization of the sector is likely to bring profound changes, and will no doubt continue to evolve from here.”


Don’t lose that entrepreneurial spirit

Many of these profound changes are already in progress. In today’s challenging investment environment, hedge funds are attracting institutional investors with the prospect of relatively high returns and minimal correlation to other asset classes. But these investors also expect a first-rate quality of reporting and infrastructure and a high-touch level of service. Managers are trying to strike the right balance between what has historically been their ‘entrepreneurial spirit’ with a more ‘institutional-quality’ approach. Managers need to stay nimble, entrepreneurial and opportunistic to deliver alpha, but they also need to be managed in a highly professional, institutional quality way to deliver confidence to investors and regulators. We believe that focusing on the following five key factors would help to enhance that confidence:

  1. Pro-active partnership and alignment of interests
  2. Standardization of investor reporting and operational due diligence, balanced with the necessary level of customization
  3. Institutional-quality infrastructure and controls
  4. Robust processes underlying the safekeeping and valuation assets
  5. High standards of fund and corporate governance

Become a trusted hedge fund advisor

While delivering strong risk adjusted returns will always differentiate a hedge fund manager, we judge that the following elements depicted in PwC's “trusted hedge fund advisor” equation breed trust.




Trusted hedge fund advisor  =






  • Transparency is the single biggest contributor to a trusting relationship.
  • Credibility fosters trust based on the manager’s words, skills, expertise and experience, and also based on the quality of the manager’s key personnel and that of its service providers.
  • Reliability relates to the predictability of the manager’s actions in terms of its strategy, performance, communications and controls.
  • Alignment of interest conveys the manager’s commitment to investors’ needs, including an appropriate level of transparency, and in some cases a degree of collaboration that verges on partnership.
  • Self-orientation affects trust profoundly. Having the right behaviours, proper structure and effective governance builds trust significantly. By contrast, a manager that puts its own interests before its investors’ will erode trust.

Institutional quality

The shift in the investor base is changing the nature of the hedge fund industry. As investors push to minimize operational risk in the industry, they’re driving institutionalization of the industry that is preparing it for sustainable future growth. The demands of investors and regulators for more transparency and better controls are adding significant cost to hedge fund managers’ operations — making scalable operations important. But they’re also creating a safer and more sustainable sector that can access a broader range of investors. While the 2008 credit crisis accelerated the sector’s evolution, institutionalization had already been happening. The quality of people, controls and processes was already increasing, but investment in these areas has accelerated in the past four years, in part following the earlier evolution of other sectors of the investment industry. 

Each member of the hedge fund value chain — manager, administrator, prime broker and custodian, auditor and director — is subtly adapting to this new paradigm. Hedge fund managers are evolving into more mainstream client service organizations. Investors themselves are also taking part in this evolution, forming closer relationships with managers that we describe as "proactive partnership". Hedge fund managers and administrators will continue the process of standardizing their responses to operational due diligence questions as they seek to reduce the costs of transparency and controls. For this reason, we anticipate a shift from a “pull” system to a “push” system whereby proactive and innovative practices such as due diligence days, different delivery mechanisms, internal control reporting and standardization of reporting will increase. Under pressure from investors, fund managers and offshore domiciles will slowly improve fund governance. New practices may also emerge regarding how administrators verify funds’ underlying assets and prices.

As institutional investors make strong operational controls and transparency a condition of investment, so they will only invest with the hedge fund managers with infrastructures that make the grade. Emergence of more institutional-type managers will also facilitate convergence with regulated products. To some extent, convergence is already happening — both through institutional investors such as pension plans and through retail investment products — but it will accelerate, driven by the managers that have strong brands, infrastructure and distribution. But as the sector gets larger and operational risk diminishes, investment performance remains paramount. Should today’s managers not deliver, a new set of entrepreneurial managers might well emerge — offering an ‘alternative’ to the alternatives. Institutional quality infrastructure should remain a focus in order to meet the increasing investor and regulator demands; but not at the cost of a manager’s entrepreneurial spirit.

From black box to open book

The US hedge fund industry is in a period of rapid evolution as it completes the transition from “black box to open book”. Yet this evolution is unfinished. In some areas further refinements are needed to improve investor protection and generally the process of giving investors and their proxies transparency has to be made more efficient in order to avoid excessive costs for all. For an industry that thrives on exploiting inefficiencies in financial markets, the hedge fund industry is sometimes inefficient itself. Duplication in areas such as ‘shadow accounting’ can be minimized and due diligence reporting can benefit from further standardization.

The industry’s transition will bring challenges as managers adapt to investors’ and regulators’ growing demands and the costs that accompany them. Yet managers also have opportunities for growth from ‘big ticket’ institutional capital investment that are far greater than ever before. What’s more, the growing culture of compliance and institutionalization is not completely incompatible with the dynamism and entrepreneurialism that gives hedge funds their edge. While risk is being squeezed out of the mid and back office operations, investors accept that the front office will need to continue to take risk in order to make returns. 

In order to complete its evolution, win the trust of institutional investors and regulators, and in turn fulfill its growth potential, we believe the sector needs to refine and improve the transition it has started. By concentrating on those areas highlighted above, hedge fund managers will be able to demonstrate the high credibility, reliability and alignment of interest, all combined with low self-orientation, that lie at the core of being a trusted hedge fund advisor.


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