AIMA

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Alternative Investment Management Association Representing the global hedge fund industry

Operational due diligence challenges facing investors in Asian hedge funds

Jason Gerber

Rogers Investment Advisors

Q2 2008

 

When considering the significance of operational risk in the hedge fund industry, the well known and often cited study by Capco, “Understanding and Mitigating Operational Risk in Hedge Fund Investments” (1), is frequently referenced. Capco concludes that 50 percent of hedge fund failures “could be attributed to operational risk alone”. Investors in Asian hedge funds frequently fail to understand how much greater the chances are of operational problems in Asia. As the former manager of operations, at one of the first Japan only long/short hedge funds (launched in 1999), I found that most investors spent very little, if any, time on operational due diligence.


The four most common operational risks identified in the Capco study were;
• misrepresentation of investments,
• misappropriaton of funds,
• unauthorised trading and;
• inadequate resources.
 

The first two can broadly be characterised as fraudulent behaviour, which suggests wilful intention to harm investors. The other two have to do with controls, compliance and adequacy of resources, which do not reflect harmful intent per se but which are caused by deficiencies or gaps, that could be mended with proper education and/or additional resources. This discussion will focus specifically on procedures, controls and systems that are typically managed by operations, administration and accounting functions among Asian hedge funds.

1. State of Operations in Japan and Asia

Before addressing specific operational circumstances in Asia, it is important to note that significant differences exist between the various markets due to (a) the stage of the development of their markets and (b) their respective regulatory regimes. The two are naturally somewhat interrelated.

In broad terms, all Asian hedge fund markets, including Japan, are still in their infancy compared to the US and Europe and consequently we find that operations talent with hedge fund experience is very limited. Similarly, the scale of hedge funds in Asia is quite small compared to the US and Europe. Although size is not necessarily a determinant of operational sophistication, there is generally a correlation between assets under management (AUM) and sophistication of systems and the number of dedicated administrative staff, which usually coincides with greater separation of function and an environment of improved controls and procedures. The following analysis contrasts an ideal state with some of the conditions we have witnessed in Asian operations. In some cases we have concluded that a manager is not able to resolve sensitive issues sufficiently or is unwilling to accept advice on how to make such improvements. We consistently reject managers whose operational shortcomings raise red flags such as these.

Trade cycle
The ideal state of trading functions is one in which trades flow through external service providers and internal systems in a highly automated environment, approaching “straight-through-processing”. In practice, particularly in smaller firms and notably among Japanese managers, we have found many instances where several of the steps in the process are manual. This has resulted, in some cases, in a relatively high level of mismatches, trades not getting completed, trading errors and other problems which may adversely affect the performance of the fund.

Internal accounting
Ideally, internal accounting systems also have a high degree of automation with the end result being exceptions-based reconciliation and accurate, comprehensive, internal net asset value (NAV) calculation. In practice, we often see manual procedures, incomplete and/or sporadic reconciliation and simple and/or infrequent NAV calculation. Where we have observed the former, there are frequently instances where items are missed, in some cases resulting in incomplete trade execution, due to imprecise knowledge of actual holdings and leading to an inaccurate NAV calculation. Since fund administrators, to whom most hedge funds outsource official NAV calculation, will from time to time make mistakes in their calculations, we believe that to be sure that external reports are accurate, internal NAV calculation is indispensable and results in fair and proper allocation of profit and loss to each investor. Additionally, we have seen numerous examples of miscalculation and misunderstanding of foreign exchange hedging.

Key Man Risk, Fraud
Clearly, the ideal scenario would be for redundancy of key staff. However, it is common to have significant key man risk in the primary portfolio manager or trader and frequently in the administration/COO role as well, even in larger firms. Similarly, organisational complexity with checks and balances, internal controls and strong separation of function, may help to reduce the likelihood of fraud but these features are very uncommon among smaller funds in Asia. Unfortunately, recurring events of internal trading fraud, seen most recently in the enormous trading losses suffered at Societe Generale, allegedly perpetrated by an employee with an intimate knowledge of the control structure there, serve to underscore that fraud can occur even at very large financial services firms with supposedly sophisticated internal controls. One advantage of conducting operational due diligence on Asian hedge funds is that the smaller number of people at each hedge fund creates a greater span of control, which in turn narrows the area of oversight needed.

Systems Risk, Compliance, Internal Control
In the best Asian managers, we have seen sophisticated systems with redundancy in all key areas, a documented and tested Business Continuity Plan, dedicated compliance staff and strict internal controls and procedures. The falling cost of technology has helped the average manager to start up with adequate systems, though there are still frequently areas which would benefit from greater redundancy, such as multiple internet connections. All of the other items are often partially or wholly ignored, particularly in startups.

Service Providers
Support from service providers can have an enormous bearing on the profitability of the firm and in its success in executing its trade. In the best circumstances, prime broker and administrator provide favourable terms on cash, stock borrowing and execution, additional services such as IT development or risk tools and timely delivery of reports. The standard state is, unfortunately, sub-optimal to the above. Frequently, though not always, the quality of service is directly correlated with the client hedge fund’s AUM.
 

 

2. Challenges in Getting to the Next Level

In Asia, sourcing qualified and experienced personnel is perhaps the largest bottleneck to improvement in the quality of operations. Alleviating this will naturally be a function of the growth of the industry in the region, combined with an influx of individuals with comparable experience from other areas. Growth in AUM should also help to provide the means to increase both staff and systems which should have a beneficial impact on all of the areas identified above.

We believe service providers could play a larger role in cultivating their managers. The prime broker (PB) typically provides standard risk tools for their PB clients and is usually willing to help managers to automate operations. The PB in particular is both motivated to be sure the manager is successful and well positioned to provide support and advice to its PB clients. It behoves PBs to make the most of this role in guiding managers to create funds which are robust operationally. We conduct ongoing reviews of the products offered by PBs to their hedge fund clients and take the level of support offered into consideration when making investment recommendations.

Similarly, national regulators are (or should be) motivated by a desire to create an environment in which hedge funds can operate in a stable and robust manner. In situations where regulators have taken a pro-active role to stimulate a local hedge fund industry (which potentially has beneficial side effects, such as job creation), they have in many cases also undertaken to establish requirements which enhance the quality of the funds they regulate. For instance, managers holding an Australian Financial Services (AFS) licence must, among other things, develop a compliance system which is audited periodically.

Finally, investors clearly have an interest in managers with stronger and more robust operations. It seems, formerly, most overseas investors more or less ignored operational due diligence in Asia. Recently, however, some institutional investors are placing greater emphasis on operational due diligence, though this is usually conducted by a team working out of Europe or America and is frequently a “check-the-box” exercise. This approach often fails to grasp the nuances of operations and settlements in Asia. We think that investors can play an important role by advising and guiding newer hedge funds to improve their operations and even more so, by acknowledging the additional operational complexities involved in Asian hedge funds. We believe that the best way to do that is by being located in Asia, which offers enhanced understanding of the challenges the manager faces and a more intimate familiarity with the fund and its service providers.

(1) Kundro, C., and Feffer, S. (2003), “Understanding and Mitigating Operational Risk in Hedge Fund Investments”, a Capco White Paper.
 

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