Risk and Responsibility

Risk and Responsibility

By José Santamaria, Director, Business Development, RBC Dexia Investor Services

Absolute return strategies have proven effective at generating alpha, but as institutional money continues to fuel the sector, this continued growth imposes new operational risks and responsibilities on hedge fund managers. That they are centred in the back office doesn’t mean they matter less than investment strategies, asset class expansion or arbitrage opportunities. In fact, the challenge to keep pace with the operational performance of the hedge fund industry is quickly emerging as a principal constraint on its growth.

Trading desks are where investment bankers and fund managers are forever deploying new strategies, inventing new instruments, tapping into emerging markets or seizing unexploited opportunities. It is up to back office experts to turn the front office ideas into the humble realities of securities safe-keeping, entitlements collected and timely, accurate reporting. If the gap between the level and complexity of front office activity and the back office infrastructure becomes too wide, the potential operational and settlement risks to market participants and their clients can be significant.

Signs of Strain

This is reminiscent of the challenges confronted by the American securities industry in the 1970s and its European equivalent in the 1980s, with the clearing and settlement backlogs that imposed severe non-investment asset selection pressures on fund managers, their clients and the banks that serviced them. Signs of similar strains are once more becoming apparent today.

The largest buyers of OTC derivatives are, of course, hedge funds. The hedge fund industry has grown so rapidly in recent years that the operational strains imposed by that growth and success have not attracted the attention they warrant. Only now is the first evidence of increased operational risk starting to emerge. Similarly untested risks are now emerging in the hedge fund administration industry, whose accountants are responsible for the valuation of the assets and liabilities of hedge funds, fund of hedge funds and structured products.

Primarily domiciled and serviced in offshore locations, hedge funds sought knowledge of partnership accounting and the ability to service master/feeder funds from their administrators. Their investors, mainly high net worth and family offices, sought only investment performance. Provided it was delivered, they were content with monthly or even quarterly NAV calculations by hard copy reporting.

Evolving Standards

Institutional investors have been enthusiastic entrants into the alternative space and this has had a direct, positive impact. Their demands for transparency, operational and risk management excellence, timely reconciliations and valuations, delivered by electronic or web-based reporting have acted as a timely reminder to the industry that standards must evolve. Hedge fund managers have moved rapidly to satisfy these new demands, with many acknowledging that the best way to improve the operational and risk infrastructure is to outsource to third party administrators. That, in turn, has led to the relatively recent entrance of global custodians into the alternative investment administration business, operating alongside independent providers and prime brokers.

The second factor behind the drive to improve standards and transparency was the realisation by long-only funds that they could also be players in the alternatives market. In Europe, the UCITS III Directive has considerably expanded the range of eligible instruments that can be deployed by managers, enabling them to replicate hedge fund activities. Mutual fund managers are now using long/short strategies and structured products as part of their overall offering for mainstream retail funds. New products, such as the 130/30 fund, are evidence of the ambitions of traditional managers, as is the significant growth in the use of OTC derivatives.

The industry must step up to the challenge to raise service standards, create capacity, reduce processing risk and improve operational efficiencies. If the industry can achieve these goals, alpha generation strategies will continue to generate excitement among not only investors and the front office but also the middle and back offices.

Transcontinental Media G.P.