Hedge funds: Make sure nothing’s lurking

This article was originally published on benefitscanada.com

More than one third of investors have included hedge funds in their portfolio, found an informal poll of execs at a recent CIBC Mellon event in Toronto.

When asked if they were invested in or plan to be invested in alternatives, hedge funds also drew the most interest.

Read: Are hedge funds suitable for the average investor?

While these funds can provide some investors with great returns, however, they often use riskier strategies. They also have a lack of liquidity and there’s little public information about them.

This is where operational due diligence comes in, since it ensures the operation of the hedge fund is above board and managed in accordance with best practices, says Esther Zurba, director of Castle Hall Alternatives.

Read: 4 facts about hedge funds

It involves both objectivity and subjectivity, she says. “You’re looking at the overall quality of a manager’s business. Measuring business strengths and weaknesses against constantly evolving industry best practices expands the conversation beyond the finer details of operations and accounting to evaluating broader business risk.”

Investment managers also play their part in mitigating risk; Ken Phillips, CEO of HedgeMark International, says over the next 5-to-10 years, there will be a global shift toward more transparency.

Read: Define and manage corporate risk

He adds the move toward position-level and enterprise risk is global and growing every day, and asset owners and fiduciaries are increasingly relying on forward-looking risk—with respect to their asset allocation and risk management techniques.

“As a result of these trends, hedge fund managers are becoming much more sensitive to the fiduciary concerns of their institutional investors,” says Phillips.

“Concerns with negative pre-selection bias have largely diminished as managers have become increasingly flexible on issues of managed accounts and transparency. As the industry matures, there is greater understanding of the requirements of fiduciaries to have proper control and oversight over their investments, which is translating into growth in managed accounts and bank-sponsored managed account platforms.”

Read: Duty of care

Although the landscape is changing, however, there are still not enough managers who are fully transparent. “It’s only about 9% that are suspect and are making headlines,” he says, “and those 9% have the potential of introducing enormous investment and reputational risk.”