Hedge funds must learn to open up a little while clamping down on operational risk management, according to a recent web presentation by Deloitte & Touche Tohmatsu.

As scrutiny over the $2 billion, growing industry from regulators and institutional investors alike intensifies, these typically small companies must increase their internal controls, and take greater ownership of valuation and other processes frequently outsourced.

Historically, hedge funds, accustomed to little oversight and secret-sauce investment strategies, have struggled with issues of compliance and disclosure.

"The industry continues to try to strike a balance between what should be encouraged as best practices without revealing too much," said Paul Doherty, a principal with New York-based Deloitte, who specializes in operational risk.

In a survey of 60 hedge fund managers around the world representing $75 billion, Deloitte found that fewer than half had a chief risk officer, and of those that did, only about half were full-time posts. In addition, 66% said they have a chief operating officer and 88% a chief compliance officer.

No matter what the structure of a hedge fund's management, the foremost concern is that the entire team is aware of the operational risks involved and has committees to form strategies to control them, according to Deloitte. Such diligence instills confidence among investors and regulators, and requires constant in-house oversight, Doherty said.

"The focus must be on ownership of your records and knowing and understanding the information you furnish is accurate," said Will Slota, a Deloitte manager. That means less reliance on outsourcing, he said.

"As funds grow in size, there must be a shift from an outsource mindset to a software mindset," he said.

One of the risks most concerning to hedge fund managers and regulators alike is valuation.

The survey showed that while 78% of the hedge funds surveyed said they used a third-party service provider to calculate the net asset value of their fund, only 47% used a third party for pricing.

"The implied risk of self-administration is a lack of independence," said Nora Duffy, a senior manager at Deloitte specializing in price and value. At the same time, administrators must be self sufficient enough to produce the types of reports and furnish the data investors need on demand, she said. The role of the third party should be one of affirmation, not information, she said.

Still, she said, "the use of administrators does not completely resolve the problem."

Fund operations committees should have written procedures and a set of internal controls. Those controls should be tested regularly, she said. Discrepancies between the records of administrators and third-party providers must be noted and explained. After all, Duffy said, the ultimate responsibility for price accuracy falls on the shoulders of the fund board of directors.

Similarly, managers of hedge fund-of-funds must be vigilant about the operations of the funds they hold.

"What they should be doing is monitoring the risk and the aggregate risk [among funds]," said Deloitte Senior Manager Karl Ehrsam, who specializes in audit procedures. "They also need to understand if the underlying managers are drifting in their strategies," he said.

Such cases are where the balance between transparency and tipping the fund managers' hand becomes most important.

"If a hedge fund cannot provide transparency that investors request, it might point to an operational problem," Ehrsam said.

Institutional investors, such as endowments, pensions and other hedge funds, are savvy enough to understand hedge fund strategies, and comfortable enough not to expect to see full listings of short positions, for example.

However, they do want assurance that risk controls are in place, and that they can trust that the manager has sufficient information himself, Ehrsam said.

"Transparency is not a full position disclosure," he said. "It's really understanding and being able to assess what the manager is doing."

Institutional investors seek security, he said. Undisclosed side pockets, especially if they represent a large portion of the total assets under management, threaten even the most sophisticated investors' confidence, he said.

Transparency can best be supported through codes of conduct, risk ratings systems and sharing conversations with regulators with investors.

Hedge fund managers that can provide audits of their financials will curry confidence. Frequent audits, perhaps set to align with the audit schedules of their largest institutional investors, is also recommended, Ehrsam said. This is especially important in light of the American Institute of Certified Public Accountants' AU 9332, which requires the audits of institutional investors themselves to reflect the risks in their alternative investment decisions.

The rule also makes it critical that fund managers be willing and able to quickly respond to their investors' requests for information, said Ehrsam.

Controlling disclosure and transparency points at hedge funds can be accomplished by bringing functions they once outsourced back in-house. In turn, that change creates a need for managers to adopt more software and technology to manage it, Slota said.

Hedge funds should ensure that the many pieces that they focus on are all integrated and that the information is complete.

"The big picture is: do you understand and are you confident in the input system and output of your fund, and can they drive transparency?" Slota said.

That said, Slota noted the lag in software solutions for the challenges hedge funds face generally lags needs by about six months. "The ultimate goal is, we need to see this information can be consolidated in a repository," he said.

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