The operational strength of a hedge fund is now just as important to institutional investors as the pedigree and track record of its manager. And fund managers are taking notice

That’s the message of a recent forecast on the hedge fund industry issued by Rothstein Kass, a New York accounting and audit firm specializing in the alternative investment industry.

The study, entitled “2010 Hedge Fund Outlook: Back to the Future?,'' analyzed 381 hedge funds. Respondents included portfolio managers, research directors, and chief financial officers. About 23% of the funds had assets of over $500 million

“Traditional approaches to due diligence processes have sought to align risk exposures with potential rewards,” says Jeffrey Kollin, a principal in the financial services advisory practice of Rothstein Kass who co-authored the report “Perhaps because they offer no direct compensating rewards, operational risks have often been overlooked.”

However, in response to demand for greater transparency, 90% of the hedge funds are developing best practices for valuation, trading, clearance and financial reporting.

That means that hedge fund managers must be able to clearly document to investors how to value and process their transactions and what third-parties are involved – aka fund administrators and prime brokers. Such an analysis often takes place either in-house or through the use of a third-party auditing firm such as Rothstein Kass.

The increased focus on operational due diligence and compliance procedures has prompted hedge funds to outsource their non-investment functions.

“In an industry that is still sometimes viewed as secretive, the quality of service provider relationships can actually be a critical consideration for investors with a wide range of options available,” says Kollin. Those non-investment funds typically include valuation and fund administration.

The Rothstein Kass study also found that about 75% of hedge funds will maintain independent custody of assets.

Such independent custody means that the assets of the fund will be segregated at a custodian bank instead of a prime broker which can rehypothecate their assets -- meaning use them for their own funding purposes. As was evidenced in the case of Lehman Brothers’ bankruptcy, the reuse aka rehypothecation of client assets in its European arm meant that fund managers are still waiting to recover their assets.

Among other findings of the survey: about 57% of funds with over $500 million in assets say they will consider lowering fees in exchange for longer lock-up periods. An even higher percentage -- about 64% of funds with under $500 million in assets will do so.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.