Another guide to (obvious) hedge fund best practices

Hedge Fund Regulation 17 Sep 2009

rubberstampAs hedge funds and funds of hedge funds dust themselves off and start looking to rebuild and reallocate cash, the words “best practices” are suddenly coming back in vogue, with standards and guidelines on what investors can and should expect to be followed if they are going to venture back into the funds of funds waters coming out of the woodwork.

The International Organization of Securities Commissions (IOSCO) is the latest regulatory body to release a short list of standards investors in particular should be looking for when it comes to the fund of hedge funds group — recommendations mostly focused on liquidity risk and due diligence.

Of course, AllAboutAlpha along with most others in the alternatives industry take due diligence recommendations very seriously, especially when they come from regulatory agencies assigned with the tall mandate of uncovering fraud and other wrong-doings.

Which is why we were keen to get our hands on Iosco’s Elements-of-International-Regulatory-Standards-on-Funds-of-Hedge-Funds-Related-Issues-Based-on-Best-Market-Practices report released this week, in the hopes of gleaning some valuable new insights on the nuances of proper, intricate due diligence.

Among the agency’s recommendations:

  • That a fund of hedge funds’ manager should make reasonable enquiries to enable it to consider whether the fund of hedge funds’ liquidity and that of the underlying hedge funds are consistent.
  • In particular, the fund of hedge funds’ manager should consider whether the level of the underlying hedge funds’ liquidity is appropriate and sufficient for the fund of hedge funds to meet any redemption or repurchase obligation to its unit holders or shareholders pursuant to the fund of hedge funds’ prospectus.
  • Before and during any investment, the fund of hedge funds’ manager should consider the liquidity of the types of financial instruments held by the underlying hedge funds.

In addition, the Technical Committee that authored the final report noted that limited redemption arrangements for the purposes of dealing with liquidity issues “should be clearly specified in the fund of hedge funds’ prospectus for the investors to be appropriately informed; should only be activated for a limited period of time; and should be taken on a collegial basis.”

In short, do the obvious: poke, prod, question, question again and, most importantly, be sure you have enough cash on hand to pay back your investors if all your underlying managers implode or abscond, even if you use leverage.

Of course, funds of hedge funds play a critical role in the alternative investment universe. They are the allocation lifeblood for many hundreds of hedge fund managers, and they are the gatekeepers for many investors, retail and institutional alike, who want diversification without the worries of overseeing multiple managers at the same time.

The good ones – and there are many of them down but not out – have hundreds of managers in their Rolodexes, and employ sophisticated quantitative and qualitative analyses on each underlying manager they eventually do allocate to.

The bad ones — the single-strategy in funds of hedge funds in disguise who allocate to only a few hedge fund managers they have “relationships” with, or worse, allocate to but one run by a guy named Bernie, as was the case among several well known funds of hedge funds, are few and far between, but inevitably lurking out there under the surface — even now.

Doing the due diligence game is more art than math or science, which is why we don’t fault the IOSCO and many other firms and institutions who have come out with “best practices” guidelines.

What would be nice would be to see more statistical and empirical “stress test” applications made part of a broader industry mantra – something that at the end of the day can show how susceptible a manager – or investor – is to a potential black swan event.

It remains to be seen who comes up with such a practice first, or at least one that has some teeth to it. Our bet is it may not be the regulators.

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  1. CeB
    September 18, 2009 at 8:06 am

    “What would be nice would be to see more statistical and empirical “stress test” applications made part of a broader industry mantra …”

    True but the reporting standards need to be consolidated, rationalized first with a technological aggregating soluition it in the middle. I suppose that’s what the FSA/SEC reporting framework is gravitating to.

    Where are the investor demands in all this? Who is the voice of all the investment fiduciaries out there? By definition, a fiduciaries obligations to his/her clients sets the bar far higher for reporting than any regulatory reporting requirements. All these regulators, standards bodies are spitting out the regulatory moors but, frankly, if one CalPERs, Harvard, et. al. stands up and says these are my standard reporting requirements, the industry will be motivated economically to comply and can rally around a set of real and specific standards.

    Until regulators, standards bodies get past the “what you SHOULD do” to “how you CAN do it” it’s all fluff on the ground.

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