Despite operational risk reporting standards, chasm remains between hedge fund investors and managers

No one will likely be shocked to hear that investors weren’t overjoyed with hedge fund transparency even before the Madoff affair.  This is the headline finding of a survey conducted last fall and released on Friday by French research institute Edhec-Risk Asset Management Research Centre.  But the 72-page study based on the survey of European institutional investors also reveals some more interesting findings.

Hedge fund investors say operational risk reporting is relatively unimportant…

While a wide gap exists between the importance placed on operational risk reporting by hedge fund managers and investors, investors actually value other types of reporting much more than they do operational risk reporting.

The chart below from the report shows that investors are totally unimpressed with current operational reporting.  But note that they also value “operational risk” reporting less than all but one other form of reporting (that being reporting on the manager’s “qualitative outlook”):

This will come as a surprise to those who assume operational risk is the #1 concern of investors.  After all, previous Edhec studies such as this one written in 2005 concluded that

“A detailed analysis of past causes of failures clearly identifies operational weaknesses as the main source of hedge fund default.”

Managers say operational risk is least important

Investors’ dissatisfaction with operational reporting is likely a result of the fact that managers think its even less important.  The chart below from the report shows that the two areas of greatest dissatisfaction (operational and liquidity risk) are also the two areas with the largest divergence between the importance placed on them by managers and investors:

Despite their reputation for ignoring the desires of their clients, hedge fund managers often do respond to what their investors say is important.  So the lack of importance placed on operational risk by hedge fund managers may be a response to a lack of pressure placed on the managers.

if so, this wouldn’t be the first time that hedge fund investors took a harder line with pollsters than they did with their own hedge fund managers.  As we reported last year, a spring 2008 survey by KPMG found that institutional investors said they would “favour” managers who voluntarily signed on to the HFSB’s guidelines.  Yet a survey by Kinetic Partners in the fall found absolutely no hedge funds had yet been asked by clients to sign-on to those guidelines.

“Detailed Advice” on operational risk reporting apparently not helping the situation

Unfortunately, guidelines published by several trade groups have not seemed to help.  In fact, operational risk reporting guidelines provided by AIMA, the HFSB and the PWG don’t appear to have created a common language to bring managers and investors closer together on this issue (see chart below from report – click to enlarge):

Perhaps operational risk report is just so mind-numbingly boring that both managers and investors wish it would just go away.  In any case, a chasm exists between managers and investors when it comes to nearly all types of reporting.  And in nearly all of these cases, investors place a higher importance on reporting than did their managers.  So it will be interesting to see if the Madoff affair provides the necessary impetus to close these gaps in the coming year.

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One Comment

  1. David Merkel
    January 26, 2009 at 5:09 pm

    This is just a guess, but here goes: Institutional investors are used to the operational transparency/reliability of regulated products that are simpler. They are not used to digging into the nuts and bolts of operations — it is boring, as you point out, and the payoffs are uncertain. Loss prevention is always duller than hearing a good story about the advantages of an investment group’s past successes and durable advantages.

    But with anything unregulated and unusual, this sory of due diligence is critical.

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