A white paper from the Bank Of New York urges institutional investors to perform independent due diligence checks of hedge funds regarding certain operational best practices. “These fairly straightforward checks can help you avoid all of the blow ups that are widely reported in the press,” said David Aldrich, managing director at BNY and coauthor of the paper with Reiko Nahum, ceo of Amber Partners. “We’re saying look beyond the obvious. Because you have to assume that in the obvious scenario, if there is a fraud that is going to be taking place, the obvious checks will be in place,” he added.
Of the five areas identified in the paper, Aldrich noted the issue of portfolio pricing is particularly important as complex securities, such as over-the-counter derivatives, become more common. According to the paper, valuation transparency, consistency and independence are the critical areas of operational risk that institutional investors should pay attention to. “You want to know how it’s being valued, why [a particular method is used], when, and who is valuing it for each specific security. We’re talking about levels of detail which will be difficult to get unless you’ve got significant influence with the manager,” Aldrich said. Other areas of operational risk that should be examined include the experience of operations personnel, compliance policies, internal controls, and the quality of third-party service providers.
Aldrich noted that while these issues have always existed, the increase in investments into hedge funds by institutions, such as pension funds, mandates greater oversight in order to protect the investments. “No pension fund can perform all of these checks... yet their fiduciary duty requires them to perform the checks before they make these investments. You can only square the circle by having an independent check,” he added.