"The Ascendancy of Risk Management
Posted By Alpha Male On April 30, 2009 @ 8:36 pm In Today's Post | No Comments
We conclude a week covering hedge fund operations issues with a guest contribution from Abdul Sheikh, CAIA, a Vice President at State Street’s fund administration group. Sheikh makes the case that many attendees of GAIM Ops also made: that independent fund administration may be the only way to fully address investor concerns in the post-Madoff world.
Alternative Viewpoints: The Ascendancy of Risk Management
Special to AllAboutAlpha.com by: Abdul Sheikh, State Street Fund Administration
In the past years, investors used to select fund managers based on three criteria: performance, philosophy and pedigree. But in Deutsche Bank’s annual Alternative Investment Survey released last month (see  related post) , “risk management” entered the ranks of the top three selection criteria for the first time, and “pedigree” fell to fifth.
It’s clear that we are witnessing a paradigm shift in manager selection and asset allocation criteria. Gone are the days of just looking at attributes like track records, top down vs. bottom up approaches, low correlations to markets, and manager size. Recent events have shown that investors need transparency, independent risk analysis, and independent asset servicing.
A State Street study conducted late last year in conjunction with the 2008 Global Absolute Return Congress (see  related post) reinforces this - indicating that five out of six institutions (84 percent) expect more disclosure of hedge fund positions and nearly half (49 percent) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19 percent) currently receive some level of consistent transparency across hedge fund holdings. (See chart below from report)
Institutional investors may believe their portfolios are well diversified. However, do they really know what their concentrations are and what these concentrations mean to them? Depending on the strategy, the managers may be allowed to take on leverage, but only a thorough analysis can determine whether that leverage is accidental or deliberate (and thus beneficial to the overall portfolio). However, this kind of thorough analysis usually requires position-level transparency.
Heightened concerns over transparency and risk management are increasing demand for independent asset servicing. Functions such as securities processing, fund accounting, reconciliations, security settlement and safekeeping are no longer viewed as value-added but necessary. Many industry experts think that the Darwinian processes occurring for the past year will separate the “premier league” of funds from the others. Based on the result of the surveys above, these premier league funds will likely be distinguished by their ability to employ independent asset servicing, provide transparency and use better risk management systems.
Some of these basic asset-servicing functions have traditionally been provided by investment banks and prime brokers. But some are now calling for third party custodians who hold customer assets “off the books” in custodial accounts. Since prime brokers have much more extensive rights in client’s assets - including their ability to rehypothecate their client’s assets - some argue that they expose investors to additional risks.
Without a doubt, we are witnessing an unprecedented transformation exemplified by increased regulation and a heightened risk aversion. As cases like Madoff and Stanford have proven, regulatory oversight sometimes provides a false sense of protection. And that is why investors seem to be saying that fund-level risk management has become more important than ever.
- A. Sheikh, April 2009
The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or State Street Corporation.
Editor’s Addendum: Sheikh’s State Street colleagues seem to agree with his assessment as evidenced by  this FT piece earlier in the week:
“‘The old system seemed to work pretty well as long as assets grew,’ says Jack Klinck, head of global investment product services at State Street. ‘But now investors are really nervous. There’s a tremendous focus on ‘who’s your counterparty?’”
“Mr Klinck expects to see a number of large US hedge funds, which have until now done all their administration in-house, outsource this function in order to reassure their clients. ‘Self-administered hedge funds are looking like outliers now. They’re having to break their operating model.’”
Finally, before the AllAboutAlpha.com corporate jet departs the Cayman Islands, we thought you might find  this recent Hedge Funds Review Cayman supplement to be kind of interesting:
“There is no doubt the global financial crisis and the push for tighter and more onshore regulation of hedge funds will change the industry forever. Cayman’s role in this is unclear but the government, regulator and industry are confident they have the skills and will to keep the jurisdiction as the number one domicile.”
Article printed from AllAboutAlpha.com: http://allaboutalpha.com/blog