January 29, 2013

The weakness of the leadership structure on the control side of the house would be fine of course if all hedge fund managers had the talents and ethics of a Warren Buffet. With this many hedge fund managers, however, not everyone is going to be and sometimes those who fall short may be tempted to enhance performance by cheating. Weak control functions make them all the more likely to succeed in doing so. Raising the bar in this area would, it is true, raise the cost of entry into the industry. However, while that might penalize a little, the great and the good, it would also more importantly serve to filter out the bad and the ugly.

So how can the bar be raised? The push seems most likely to come from investors. For a start, one area of focus should be on ensuring greater transparency into funds' investment decision and trading processes. How about, for instance, requiring discussion and then registration of any potentially “material non-public information” (mnpi) with a control group internal to the fund and independent of the trading team? Such a group of course already occurs at investment banks to a sophisticated level and at some of the more firmly established hedge funds. Investments and trades can then be cross-checked against the “mnpi registry”. Additionally, information upon which an investment thesis has been based could be reviewed by control and compliance functions. If the thesis is found to be based, in part, on “mnpi”, then the proposed investments or transactions would be pulled.

Additionally, like at investment banks, an independent compliance function should be surveilling market events and cross-checking in an automated fashion (after the fact) for any trades ahead of those events. This type of control is absolutely standard in investment banks and it should be so also at hedge funds and other asset managers. The experience of a friend of mine illustrates the potential value of such an approach, difficult as it would be to implement effectively. He is the CFO of hedge funds, one of the most experienced on the Street but found himself on the receiving end twice of portfolio managers who did not provide sufficient transparency into the investment process. The first time, as CFO of a credit fund, he did not have full transparency into the extent of sub-prime investments in the portfolio. The second time, as CFO of an equities fund, he was not provided with information regarding the nature of the data upon which investments and trades were being made, some of which was later alleged (with ultimately a guilty conviction for several of the portfolio team) by federal prosecutors to be based on “inside information”. The CFO was blind-sided in both cases in part because he was, in effect, treated not as an investment partner but as back-office. Had he been fully brought into the investment process, with much greater transparency, he may have been able to help avert the crises that overtook the funds in both cases. In other words, portfolio managers require supervision but very rarely do they get it or accept it.

[Re-Thinking Operational Risk on Wall Street]

The foregoing examples illustrates that there is a heavy unseen cost to insider trading which is borne, when firms close, by hard working and innocent folks in support functions. Ultimately, it will become harder to attract and retain talent into infrastructure roles in hedge funds if the risks are seen as being too great. The problem of insider trading then needs to be addressed head-on by the hedge fund community. It appears that the low-cost infrastructure and structural inadequacies of hedge funds is the most pressing to address. However, we will also look, in a follow-up column, at what the middlemen and suppliers in the chain can do to strengthen their controls and culture against the issue.

Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are ...