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What's Behind Operational Failures?

Study finds long/short equity strategy is most prone to hedge fund operational failure.

Chris Holt

As hedge fund strategies become increasingly complex, it gets more and more difficult to adequately asses the value of securities and trading strategies used. So you’d be excused for thinking that esoteric and complex hedge fund strategies provide fertile ground for operational failure.

But your assumption would likely be wrong. A recent study by hedge fund due diligence provider Castle Hall Alternatives finds that the strategy most prone to “operational failure” was long/short equity, not some screwy black-box strategy cooked up by mathematicians. The runner-up: managed futures – another straightforward strategy not particularly renowned for its opacity or complexity.

The chart below from Castle Hall’s report shows the significant ($10m+) operational failures by strategy:

Operational Failures by Strategies

How could such supposedly transparent strategies be the source of so many problems? Firstly, long/short equity is a huge category. So it’s bound to be the source of a large amount of anything. But as Castle Hall points out, most operational failures are the result of misrepresentation or misappropriation of assets – both activities that require the kind of human intervention that doesn’t exist in black box strategies (Madoff jumps to mind as proof of this assertion). In Castle Hall’s words:

“Quite simply, ‘cooking the books’ is easier when dealing with more straightforward strategies which do not involve complex securities, high volumes of trades and multiple brokers and counterparties.”

The chart below from the report shows the main reason behind the most significant ($10 m+) operational failures.

Most Significant Operational Failures

Castle Hall tallied up the losses from 327 operational “events” (a euphemism for operational failures) and found that, excluding Madoff, operational failures have resulted in around $15 billion of “financial impact”. Excluding the Petters and Bear Stearns cases, that number is around $10 billion.

That’s a lot of money. But not compared to the several trillion that was invested in hedge funds at some point over the past decade. As Castle Hall points out, 327 funds represents only a few percent of the currently active hedge funds and an even smaller proportion of all hedge funds that have ever existed. As a result, Castle Hall calls hedge fund operational failures “material, but not pervasive“.

In a finding that will surely stoke the debate over hedge fund regulation, the list of operational failures does not include one case of rogue trading in the (relatively unregulated) United States, but identifies “relatively regular” examples of it in Europe (SocGen, Barings etc.).

The biggest unsolved operational risk, according to the firm, remains the misvaluation of fund assets. And the fact that many third party administrators see themselves as “verification agents”, not a “valuation agents” does not help the situation.

Students of hedge fund operational failures may recall this oft-cited 2003 study by London-based consultancy CAPCO. This new study provides an update to previous work by including more, and more recent, hedge fund failures.

“(The CAPCO study) looked at 100 hedge fund failures and found that approximately half of them were due to operational risk factors,” explains Chris Addy, Castle Hall’s President an CEO. “Castle Hall has identified more than 300 cases specific only to operational risk, including, of course, funds which have had operational events in more recent years. This research gives investors an up to date and comprehensive view of the impact of operational failure across the hedge fund industry.”

The report coincides with a new service offering from Castle Hall that provides access to a bunch of detailed information on each case of failure. We’ve seen the tool at AllAboutAlpha.com and it’s pretty impressive – definitely a useful resource for any hedge fund COO who wants to ensure they are up to speed not only on how to succeed, but on how not to fail.

Chris Holt is the Founder and Managing Editor of AllAboutAlpha.com, a daily blog that offers alternative research, analysis and opinion. He is also a sought-after conference moderator, chairman and speaker.

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