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Perspectives

How to evaluate hedge funds' operational risks

By Irfan Yunus, Global Head of Operational Due Diligence

March 12, 2019Posted InInvestments and Hedge Funds

Hedge funds can contribute an additional source of return to a diversified portfolio. Over the coming decade, Citi Private Bank‘s annualized strategic return estimate for hedge funds as an asset class is 7.4%.i We also believe that certain types of hedge fund strategy could provide intelligent market exposure in today's late-cycle environment - see Safeguarding assets in Outlook 2019. However, their returns come with additional operational risks compared to, say, mutual funds, as they are subject to less regulation and often have fewer resources and personnel. 

In our previous article, we explained how risks from hedge funds' operations - rather from their investment activities - might have been the main reason for hedge fund investors' losses over time. So, how might we identify these risks and perhaps mitigate them?

Hedge funds’ operational risk is defined as ‘the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.’ In other words, operational risks embrace a multitude of sins. Examples include outright theft from investors, manipulating valuations and fund reporting, failing to manage conflicts of interests, hedge fund technology going wrong, and managers deviating from the agreed strategy and procedures.

This sheer variety of operational risks poses an obvious challenge to hedge fund investors. However, experience emphasizes that there are ways to identify such risks. Ahead of many prominent hedge fund failures, red flags were on display. All too often, however, these warnings either weren’t noticed or were ignored. What is required, therefore, is a thorough and disciplined due diligence process that scrutinizes hedge funds’ operations before making any investment. Here are some of the steps involved:

Vet their vital documents

Intensive analysis of a fund’s key documents is vital to assessing operational risk. These include its memorandum and articles of association, as well as the investment management agreement, and fund formation documents. Are there clear lines of segregation and organizational control between investment and non-investment personnel? Is the fund subject to a periodic audit by a leading audit firm with significant experience of reviewing hedge funds? What are its compliance infrastructure, processes, and procedures like? Does the firm have a cybersecurity policy, and what is the plan if the fund suffers a cybersecurity attack? Are the fund’s personnel fully conversant with all of this?

 

Meet the managers

The findings from a fund’s paperwork can guide face-to-face questioning of fund personnel at their offices. It’s not just the managers and principals who should answer questionnaires and undergo interviews, but also key figures such as the heads of operations, compliance, and risk. Adequate levels of staffing, experience, and segregation of duties are essential.

The 2018 case of an Australia-based based investment advisor highlights the importance of thorough manager scrutiny. The US Securities and Exchange Commission charged the advisor with completely fabricating its investment returns, assets under management, and relationships with key service providers including auditors and prime brokers, none of which had ever existed. A review of the fund’s documents - reinforced by onsite meetings with its personnel and external service providers – might have helped avoid losses for investors.

 

Dig into their past

Bad behavior is often habitual rather than one-off. Do any of a firm’s personnel have criminal records? Have they been subject to professional misconduct complaints in past jobs? Are their purported credentials genuine? One of the principals of a high-profile US hedge fund that collapsed in 2005 not only had a past arrest for possession of a controlled substance, but had also lied about his education and career.

 

Probe their network

It’s not just a hedge fund itself that can create operational risks for investors, but also its network of external service providers. This includes a fund’s administrator, auditor, prime broker, and other advisors. Are these organizations robust and are their relationships with the fund above board and at arm’s length? Prominent hedge fund scandals have frequently involved conflicts of interest with these external service providers. 

 

A proactive approach

While steps such as these are critical to identifying operational risk, they are also time-consuming, complicated, and expensive for investors to perform. Citi Private Bank’s Operational Due Diligence team therefore exists to carry out these vital functions proactively on behalf of our clients.

Citi Private Bank’s Operational Due Diligence team is an independent entity with the power to veto any fund from being included on the Private Bank’s platform.  And, since 2016, Citi Private Bank’s Operational Due Diligence program has incorporated proactive enhanced monitoring. This involves subjecting certain higher-risk managers and funds to a quarterly review relating to specific aspects of their riskiness. This involves subjecting certain higher-risk managers and funds to a quarterly review of specific aspects of their operational due diligence risks

Our role is not only to seek to highlight risks, but also to try to mitigate them. One way we do this is by insisting that certain managers take necessary corrective actions before we are willing to approve their funds. Recently, for example, we have required managers to enhance their compliance infrastructure by engaging external compliance consultants to perform mock audit examinations, hire experienced chief financial officers, ensure appropriate segregation between front and back office by splitting off the trading function, and by enhancing their controls in relation to making wire transfers.

Of course, it is impossible to eliminate operational risk for hedge fund investors altogether. However, by proactively searching for it prior to investing – and rigorously monitoring for it thereafter – we believe we can both identify and help mitigate operational risk.

 

Alternative investments are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk. 

 

Asset allocation does not assure a profit or protect against a loss in declining financial markets. 

 

iSource: Private Bank Quant Research & Global Asset Allocation team. SREs for 2019; Based on data as of October 31, 2018; Historical returns for last 10 years as of October 31, 2018; Returns estimated in US Dollars; All estimates are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Strategic Return Estimates (SREs) are no guarantee of future performance. Past performance is no guarantee of future returns. The index composites for each asset class are described in Adaptive Valuation Strategies - A New Approach to Strategic Asset Allocation 2019 Annual Update.