This is from a presentation at Financial Technologies Forum’s 2nd Annual Hedge Fund and Operations Conference on 21 April 2009. While it is just a list of bullets, it is included here for the convenience of our readers.
Interesting Points
➾ Operational risk is defined as ‘risk without reward’
➾ More than 50% of hedge fund failures relate to operational risks with a primary contributor being a basic lack of segregation of accounting roles between the front office and the back office(1)
➾ The administrators represent as many potential problems as the hedge funds
(1) Data based on a March 2003 study by Christopher Kundro and Stuart Feffer with Capco (www.capco.com). The study is based on 100 hedge fund failures over the past 20 years.
A Word of Advice: Prepare!
➾ Lists – Counterparties with ISDAs, service providers, vendors, systems
➾ Organization charts
➾ Workflows
➾ PPMs
➾ Agenda
➾ Make sure you are on the same page
➾ Agree who talks about what
#1 – Plan for the Worst
➾ Disaster
➾ Fraud
➾ Staff loss
➾ Unfavorable markets
➾ Regulatory changes
➾ Counterparty failure
➾ Prime broker failure
➾ Escalation procedures
➾ Think about all the things that can go wrong – and talk about them
#2 – Independent Oversight
➾ Independent review of investment management activity (investment guideline compliance, adherence to discipline, execution quality), risk monitoring, pricing, conflicts
➾ Independent fund administrator
➾ Independent auditor
➾ Periodic internal review – and testing – of processes
➾ Formal committees (pricing, best execution, conflict, investment review, risk)
#3 – Document processes and policies – including escalation procedures (and review these periodically)
➾ Compliance
➾ Risk monitoring
➾ Subscription / redemption (including KYC, AML and Patriot Act)
➾ Trading (including orders and executions)
➾ Settlement
➾ Cash movements and securities delivery (including margin and collateral)
➾ Reconciliation (including all collateral)
➾ Corporate action monitoring
➾ Month-end closing
➾ Pricing
➾ Fund accounting (including review of external administrator work)
➾ Counterparty selection and approval
➾ Service level agreements (internal and external)
➾ Events (orders, trades and confirmations, reconciliation – including review, pricing – what was obtained and from whom, fund accounting – review of external administrator work, investment and research meetings, committee meetings – e.g. minutes, rrade errors
#4 – Staff Appropriately
➾ Adequate headcount (including operations, accounting, compliance and IT)
➾ Knowledge, skills and experience (complex strategies require additional expertise, training, cross training, understand best practices, supervisory qualifications)
➾ Segregation of duties
➾ Clearly identified CCO and CRO
#5 – Discipline and Consistency
➾ Discipline with a repeatable process – and make sure your stats back that up! (buy and sell disciplines, investment guidelines)
➾ Consistent pricing process
➾ Consistent trade allocation policy
#6 – Ensure a Level Playing Field
➾ Provide all investors with a consistent level of information
➾ If additional transparency is provided to one investor, managers should be willing to offer it to all investors upon request
#7 – Disclose
➾ Changes to valuation policies
➾ Key personnel changes
➾ Service provider changes
➾ Changes to biographical or disciplinary information regarding the firm or key staff
➾ New side letters or parallel managed accounts that grant terms to certain investors that could, in certain circumstances, adversely impact other investors
➾ Occurrence of operational issues that could impact the fund
➾ Discovery of fraud or wrongdoing within the firm or by a key service provider
➾ When in doubt…
#8 – Due Diligence
➾ On investments (not just for fund-of-fund managers)
➾ On key service providers (prime brokers, custodians, fund administrators, auditors, IT vendors, counterparties, others)
➾ Service provider due diligence should include (at a minimum): on-site visits, initial and annual follow-up, documentation of due diligence performed
#9 – Shadow Records
➾ Investment accounting
➾ Partnership accounting
➾ Features: full audit trail; automated maturity, expiration, income, withholding and reclaim processing; user security based on roles
➾ Backups
➾ Record retention
➾ GIPS® compliance and verification
#10 – Metrics
➾ Quantify, measure and monitor material risks taken by the fund on a frequency appropriate to the fund’s characteristics (risk monitoring should be appropriate to the fund’s strategy, investments and characteristics; recognize relationships and risk factors may change over time, so review the process regularly; non-quantifiable or measurable risks should still be monitored)
➾ Business volumes, cost drivers and stress ratios, e.g.trades, wires, subscriptions / redemptions, accounts / funds, investors, fail rates, match rates, staff
Two Last Pieces of Advice
➾ Practice what you preach
➾ Be honest
Stone House Consulting, LLC 