The self-policing efforts of the $1.8 trillion hedge fund industry took a step forward with last week's release of the Managed Funds Association's guidelines for best practices in the industry.
"The updated guidance is the cornerstone of the association's initiative to collaborate with domestic and international organizations with the goal of establishing uniform global principles and guidance," said Jack Gaine, president of the Managed Funds Association.
The MFA's report was developed with input from the President's Working Group on Financial Markets (PWG), which is also developing industry best practices. Most of the participants on the PWG's asset management group are sustaining members of the MFA. The PWG said in February that the hedge fund industry was doing a good job of regulating itself.
The MFA report, entitled "Sound Practices for Hedge Fund Managers," weighs in at 276 pages. It is the fourth version of the guidelines, the first having been issued in 2000.
The MFA identified seven industry topics and honed in on them with best practices suggestions. The seven categories are: management, trading and information technology controls; responsibilities to investors; determination of net asset value; risk management; regulatory controls; trading relationship management, monitoring and disclosure; and business continuity, disaster recovery and crisis management.
"Sound Practices for Hedge Fund Managers" includes advice on operations, and it features sample questions for investors to pose to hedge fund managers on topics such as valuation and conflicts of interest.
"The biggest single addition [from best practice guidelines of previous years] is the due-diligence questionnaire," Gaine said. The questionnaire is designed to be used by all categories of industry participants, including high-net-worth individuals, pension fund managers and non-profit institutions.
The questions in the checklist will help amplify or provide additional details about the disclosures in a hedge fund's offering documents. It includes questions about who audits the investment management vehicles managed by the firm, the hedge fund's compliance regime, its policies about the handling of material, non-public information, and its written policies regarding personal account trading by employees.
Other parts of the document address money laundering controls, the firm's history of administrative or criminal proceedings, its trade execution and control systems and potential conflicts of interest created by fee arrangements, soft dollars, special relationships with brokers or side-by-side management of multiple accounts.
The detailed questions also delve into relatively arcane aspects of hedge fund management, such as the deployment of third-party software, post-trade reconciliation and whether the fund or its affiliates carries errors and omissions insurance.
Other sections of the report include recommendations to strengthen business practices of hedge funds through a framework of internal policies and practices, particularly with regard to how it trades and how much risk it assumes-and to disclose these to investors. MFA also calls for hedge funds to perform "stress tests" to determine how large changes in market prices and other risk factors could affect a hedge fund's value.
The hedge fund group strongly urges hedge funds to disclose to investors on a timely basis their investment objectives, strategies, risks to investors and method for calculating net asset value.
The MFA said that hedge funds must have fair, consistent and verifiable methods for valuing assets that trade over the counter and for which public markets don't provide a public valuation baseline. This includes derivatives and other complex financial products.
Barry Barbash, a partner at Willkie Farr & Gallagher, said the guidelines will be useful because many hedge fund managers run small operations and don't have the wherewithal or knowledge to stay current on the latest compliance initiatives.
However, Barbash cautioned that the guidelines aren't going to work for every situation in every firm. Gaine concurred that "one size does not fit all," and said that a hedge fund's board of directors should make some distinctions between what should be applied to the largest funds and to a start-up.
Lukewarm Reception
The best practice efforts of the MFA grow, in part, out of a court's rejection of a Securities and Exchange Commission effort to mandate the registration of hedge funds.
Activist hedge fund manager Phil Goldstein of Bulldog Investors, whose court challenge forced the SEC to abandon its plan to force hedge funds to register in February 2006, wasn't impressed by the MFA's action. "I don't think these steps are necessary, but they won't hurt. There's nothing wrong with publishing best practices, but there's really nothing broken in the industry," he said.
Goldstein noted that when hedge funds blow up, it is usually due to excessive leverage, an issue the report doesn't address.
He said the motivation of the MFA in putting out its best practices is to head off misguided regulation by being proactive. He maintained that is was an acceptable approach, but added that most hedge funds already have instituted excellent controls and practices.
Louis Morrell, the treasurer at Wake Forest University, said the guidelines, while useful, are no substitute for hiring experienced investment managers. "You have to find someone who's been working for at least five years so they have a track record." He noted that there are a number of nuances in working with investment managers that are outside the realm of the guidelines.
In one case he cited, the portfolio manager was reluctant to pull out of a losing investment because he had a significant portion of his personal wealth invested in the vehicle. Normally, it is a plus for the manager's personal investments to parallel his institutional holdings. But in this case, Morrell said there was too much of the individual's net worth tied up in the investment for that alignment to be ideal.
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