Due Diligence Takes on a New Meaning

Date: Wednesday, February 25, 2009
Author: Mark Noble, Advisor.ca

Do investors really know the risks associated with their chosen investments? For many of them, the answer may be no, according to Craig Asche, director of the Chartered Alternative Investment Analyst Association (CAIA).

Asche, who heads up the Massachusetts-based association that accredits the CAIA designation, was in Toronto last week to meet with key stakeholders in Canada’s alternative investment community. He points out that some money managers have not taken into account the cost of due diligence in running their mandates.

In his view, for every Bernie Madoff — outright fraudster — many more hedge funds are done in by the miscalculation of operational risks. For instance, forced liquidation has been a huge issue for hedge funds.

The short-selling ban and the collapse of Lehman Brothers left many hedge funds holding largely illiquid assets. Of course, to survive a liquidity crunch, many funds have to sell off their higher-quality assets.

“Nobody is happy with what’s happened to hedge funds, but I would argue that hedge funds are as much a victim as the investors were. A lot of the things that contributed to the poor results in hedge funds were outside their control,” he said. “Look at the short-selling bans and the problems Lehman Brothers created as a prime broker. There were a lot of losses created by those dislocations in the environment.”

These types of risks — which are obviously very real — require a reconceptualization of the risk models used by the industry.

“Certainly, on the quantitative side, there has been too much reliance on using historical data to develop the models. Clearly, these events we historically look at as being three- to five-point standard deviation events are happening with more frequency. That being the case, risk models need to be adjusted,” Asche said. “There has also been a shortfall in institutional management, those managers look at their asset exposure in terms of the assumptions they are making. In normal times, you can assume normal relations will hold.”

Asche points out these are abnormal times, and the correlations of assets have increased — mostly all heading down. Things like counterparty and liquidity risk have been major factors in strategy performance.

“If I’m relying on short-term borrowing strategies, how bad can that go wrong, and what effect is that going to have across the portfolio? It’s very difficult for people. You can’t predict what is going to happen and how it’s going to unfold,” he says. “You try to predict scenarios as best you can and say if there is one assumption across my portfolio that I’ve made that is going to cause the most damage if it goes down, what is it? How secure are my lines of credit if I need access? I think there is going to be a different approach that people make with modelling alone and making those determinations.”

However, risk modelling and looking at the strategies employed by hedge funds are only one part of the due diligence equation.

The other is the operational risk. This is an area in which specialized knowledge of the hedge fund industry is required, Asche points out.

For instance, there are growing calls for hedge funds separating some of their functions. Standard due diligence will likely require a hedge fund to have multiple prime brokers and independent fund administrators who can be audited.

“There is a very good case to be made of separating due diligence into two components. You look at the strategy. Does it fit with what I’m trying to accomplish? Is it appropriate for this structure?” Asche says. “Then you have to look at it from the operational side and really determine everything is appropriate. Does a manager have that independence? Is there enough independent verification of what a manager claims? You must separate those two assumptions so that if either side says no, it’s a no to investing with it.”

A complementary designation provider, the CFA Institute, is also weighing in on due diligence for hedge funds. On Monday, Stephen Horan, the head of private wealth at the CFA Institute, issued a number of tips on how a fiduciary can mitigate fraud risk with hedge funds. Operational red flags also ranked high on his list.

“Any investment management operation should have a physical infrastructure for trading and administration. Ask to see them and inquire about the firm’s processes and controls. It is important that a firm have separate, independent operations for asset management, trading and custody to provide checks and balances against fraud,” Horan says.

Horan suggests fiduciaries ask for audited financial statements of the organization. He stresses the auditor should be “independent, reputable and congruent with the size and scope of the investment operation.”

Finally, fiduciaries should also do a checkup on the personnel running a mandate, Horan says.

“Ultimately, the reliability of any operation is predicated on the integrity and competence of its people. So find out who manages the assets and who implements the investment strategy. They should be separate people with relevant experience, education and training,” he says.

A big question going forward may be whether retail financial advisors have the knowledge and expertise to meet these fiduciary obligations. Asche says an increasing number of individuals at the SEC are getting the CAIA designation to understand the different operational risks experienced by hedge funds and how they differ from other financial entities.

Many advisors don’t have either the CAIA or CFA designation. This may eventually call into question the fiduciary competence of advisors recommending alternative investment mandates without the help of a regulated investment counsel.

“If you don’t have the ability to do the due diligence, and you don’t have the resources to hire somebody independently to do it for you, you shouldn’t be invested in it — you just shouldn’t,” Asche says.