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INSIDE VIEW: Keeping a sharp eye on the industry

EagleThere is evidence that hedge funds are responding to demands for greater transparency and risk management, find Marios Kalochoritis and Hemaad Khan, of Auvest Capital Management.

Along with regulations such as Dodd-Frank in the US and the European Union’s Alternative Investment Fund Managers (Aifm) Directive – the first EU directive to focus on managers of alternative investments – institutional investors have been helping to drive greater transparency within hedge funds, including disclosure of information relating to valuation methodology, positions and leverage exposure.

Though the hedge fund industry suffered during the economic downturn, a recent survey by Citigroup found that the industry is expected to more than double in size during the next five years, to more than

$5 trillion (€3.8 trillion) in assets, as private fund firms broaden their offerings to compete with traditional money managers.  

The survey predicted that hedge funds could lure $2 trillion in new money to investment vehicles long associated with mutual fund companies and other institutional managers, including long-only funds that buy and hold stocks.

Such growth means regulators will undoubtedly be keeping a sharp eye on the industry. But driving the need for change has been a groundswell of investors raising the banner for greater transparency. A good indicator of how much hedge fund managers have responded to investor and regulatory sentiment is a recent report by KPMG and the Alternative Investment Management Association, which found that hedge fund management firms have increased their operational infrastructure in areas like investor transparency and regulatory compliance as allocations from institutional investors have increased.

Interestingly, 84% of the respondents indicated they had increased transparency to investors since 2008, which is reflected by the fact that the majority of firms have taken on multiple members of staff to respond to demand. The report also found that hedge funds had almost universally increased investment in regulatory compliance since 2008, with 98% of firms hiring additional staff in this area.

So there does seem to be a strong movement afoot within the industry to demonstrate activities are more open and transparent.

Need-to-know strategy
But hedge fund managers should not rest on their laurels. Greater transparency is essential, especially where offshore vehicles are involved. Hedge fund managers need to have strict controls in place and clear agreements with brokers and custodians to ensure there is a true segregation of assets. The Dodd-Frank Act, in particular, has several key implications for overseas hedge funds.

Although the requirements apply to hedge funds of $150 million or more, this does not mean smaller hedge funds should be any less transparent or relax their vigilance when it comes to managing risk.

All hedge fund managers need a risk management approach, looking at positions in a qualitative and quantitative way.

This is especially true in times of unprecedented market volatility. The economic downturn has demonstrated that traditional risk management models were not robust enough and did not manage to limit losses. Since then, risk management has risen to the forefront of investors’ due diligence processes and traditional methodologies no longer provide the additional comfort that is required.

Consequently, we have seen many hedge funds actively pursuing building in-house risk management solutions that cater for specific investment strategies and investor needs.

In the wake of the financial crisis, managing risk has become a critical issue for hedge funds. Today, hedge fund managers must manage existing risks – such as liquidity and reputation – with new and emerging risks – such as product proliferation and globalisation – as well as respond to a changing investor mentality and regulatory environment.

Large hedge funds will have risk management officers to help guide the fund through the risk labyrinth while smaller funds may have to delegate the tasks to someone in an existing role. But risk management should not just be left to a third party. It is the fund manager’s responsibility to understand everything that is going on in terms of all risks the fund may face, including what has been successful or unsuccessful.

Fund managers need to ask themselves why they are choosing certain positions or trades. The overall strategy should be a long-term, well thought out process as opposed to knee-jerk reactions to markets, or just following what other hedge fund managers are doing.

In addition to understanding their investment strategies, these managers must understand their internal systems. Information technology has brought about many enhancements in the accessibility and dissemination of information in the industry but, at the same time, it has magnified the quantity of available information. Being able to process information expeditiously and filter out noise has become a challenging and complex operational hurdle.  

Additionally, expectation for the availability of data or information is in live or near-live format. Receiving live data feeds from service providers poses challenges as information feeds in through multiple sources in different formats. Hedge funds need to have the necessary information management systems in place that catalogue, archive and process such large volumes of information. The complex IT systems required are usually not available as off-the-shelf solutions and could require infrastructural changes and added capital expenditures.

It is not enough for hedge fund managers to follow the crowd and simply respond to market changes without thinking about whether a particular trade or position makes sense for their fund. Hedge fund managers must be aware of all the risks they are taking, from the investments they make to the IT services they use.  

Marios Kalochoritis is a co-founder and managing director, and Hemaad Khan is a director at Auvest Capital Management

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