In an informal poll of investors in attendance at a recent CIBC Mellon event in Toronto, 38% of respondents indicated they were invested in hedge funds and 38% said they were undecided. When asked if they were invested in or plan to be invested in alternatives, hedge funds drew the most interest.
Hedge funds can provide institutional investors with great returns (well into the double digits sometimes), but these funds are still risky. They use high-risk strategies and there’s a lack of liquidity and lack of public information on them.
For institutional investors, that’s where operational due diligence—ensuring that the operation of the hedge fund is above board and managed in accordance with best practices—makes a difference.
“Operational due diligence continues to gain importance as an integral part of the investor’s investment selection process,” said Esther Zurba, director of Castle Hall Alternatives.
It involves both objectivity and subjectivity, she said. “You’re looking at the overall quality of a manager’s business. Measuring business strengths and weaknesses against constantly evolving industry best practices expands the conversation beyond the finer details of operations and accounting to evaluating broader business risk.”
And investment managers will play their part, too. Ken Phillips, CEO of HedgeMark International, said over the next five to 10 years there will be a global shift toward more transparency. The move toward position-level and enterprise risk is global and growing every day, and asset owners and fiduciaries are increasingly relying on forward-looking risk with respect to their asset allocation and risk management techniques, he continued.
“As a result of these trends, hedge fund managers are becoming much more sensitive to the fiduciary concerns of their institutional investors,” said Phillips. “Concerns with negative pre-selection bias have largely diminished as managers have become increasingly flexible on issues of managed accounts and transparency. As the industry matures, there is greater understanding of the requirements of fiduciaries to have proper control and oversight over their investments. This is translating into growth in managed accounts and bank-sponsored managed account platforms.”
But while there are transparent managers, there are also the not-so-transparent ones, too. (Think U.S. hedge fund manager Aleksander Efrosman who admitted to running a scheme cheating investors out of $5 million.)
However, Phillips said plan sponsors, recognizing their basic duties of oversight and accountability, probably don’t have to worry about the majority of hedge fund managers, who are honest and straightforward. Nonetheless, and although the landscape is changing, still not enough managers are fully transparent. “It’s only about 9% that are suspect and are making headlines,” he continued, “and just those 9% have the potential of introducing enormous investment and reputational risk.”
“I’m not worried about the ones who’ve already cheated,” he said. “I’m worried about the one who hasn’t been caught yet.”