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What to Expect from Hedge Funds Today

Date: Wednesday, July 20, 2011
Author: Joshua Barlow, PAAMCO

Much like the aftermath following the Bernard Madoff fraud, the allegations and prosecutions against certain members of the Galleon Group have predictably raised a chorus of hedge fund investor concerns.

Expert research consultants, independent research boutiques and expert networks (collectively “experts”) – firms that match industry specialists including those working in public companies with money managers – have fallen under the spotlight. There have been a series of high profile allegations about whether these experts were providing managers with material non-public information - such as future earnings predictions or proposed mergers and acquisitions – in exchange for a fee. Verifying that hedge fund managers have proper controls surrounding the use of material non-public information should be an integral part of investing. However, firms such as Galleon overstepped the proper use of this information which has resulted in greater scrutiny on experts and operations generally.

There are some aspects of compliance which are absolute prerequisites for fund managers – most significantly, having a quality compliance culture led from the top with a suitably qualified chief operating officer and chief compliance officer. Firms should have detailed and bespoke compliance manuals that are kept up to date with new regulations and are appropriate for the firm’s size and strategy. They should not be left gathering dust on an obscure shelf but continually reviewed and updated. Regularly monitoring trading, performing trade tests and educating staff on a frequent basis are also essential. But these are just the basics.

We, as investors, do not feel we are at the point yet where it is necessary to ban managers from using experts. Furthermore, we will still invest in managers that do utilise the services of experts. However, it is essential for us to hold managers to a higher standard and demand that they implement specific practices. At a minimum, we believe that all managers must now have detailed compliance manuals in place with written policies and procedures in regards to the use of material non-public information and experts (if they are used by the manager). The chief compliance officer or compliance group at each manager must approve all experts being used by the firm, which must include reviewing and approving the expert agreement. Each agreement should have an explicit clause that the expert will not provide the manager with material non-public information. All information received from experts must be documented by the receiver and then reviewed by compliance. Furthermore, if possible, compliance personnel should be present during any conversations between managers and experts. It is recommended that all phone conversations with experts be recorded, reviewed or documented by compliance. Training staff is also key. Companies should have annual formal compliance training for all employees interacting in any fashion with experts. These continuing professional development briefings would of course address relevant topics such as insider trading and the appropriate use of experts. Finally, compliance departments are advised to identify and sample trades based on information received by experts, and look at other trades material to the portfolio (especially the top performing trades) compared to publicly available information.

These practices are already in place at many of the hedge fund managers who hold themselves to a particularly high compliance standard. The events of the last six months have made it clear that is now necessary that all hedge fund managers maintain the same high standard when it comes to experts. Such best practices will certainly go a long way in reassuring hedge fund investors.