2013 Hedge Fund Operational Risk: The Road Ahead Part 2
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2013 Hedge Fund Operational Risk: The Road Ahead Part 2

By Kristoffer Houlihan Armilla Partners

 

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Introduction

Since 2012, the CHFA has been conducting Chief Operating Officer (COO) Roundtables designed to chronicle current issues of interest to the hedge fund community. On April 23rd in Beverly Hills, CA, CHFA held an invitational Thought Leadership Dinner to discuss hedge fund operational risk and the road ahead. This is a continuation of the dinner hosted on February 23, 2013 in Newport Beach, CA. The following is a summary of the highlights of that discussion.

Topics discussed:

  • Shadow Accounting
  • Separation of Duties at Small vs. Large Hedge Funds
  • OPERA Standards
  • Risk Management Systems for Hedge Fund Managers

Shadow Accounting
"Full Shadow" Accounting vs. "Partial Shadow" Accounting — Which is the best option for my fund?

Key takeaways:

  • Partial shadow accounting is on the rise.
  • Administrators are getting better in offering enhanced capabilities.
  • For a partial shadowing relationship to work, fund managers need to develop appropriate governance and logistical relationships with administrators.
  • Managers need to agree what items can be standardized and the cases in which shadow accounting are not necessary.

Our discussion agreed that it is common for large fund managers to engage third-party administrators to maintain their books and perform a host of back- and middle-office services, such as valuation, reporting, reconciliation and net asset value (NAV) calculation. We agreed that large managers ($5billion+) sometimes opt to conduct complete shadow accounting. This "full shadowing" strategy (i.e., maintaining a full set of books and records in-house, which duplicates 100% of what the administrator does) enables a manager to reproduce and therefore crosscheck and validate an administrator’s output.

 

But should all managers go this route? Our discussion focused on partial shadow accounting being an alternative and cost effective solution.

Key drivers of partial shadow accounting:

  • Administrators have begun to broaden their capabilities in offering middle and back office services to hedge funds. This is attractive to hedge funds.
  • There can be significant cost savings to managers by only implementing partial shadow accounting
  • As regulatory requirements become strengthened, the need for enhanced reporting, such as Form PF, FATCA, and accounting for derivatives, requires extensive accounting experience to which managers may not have expertise. Administrators can now offer this expertise.
  • Taking a partial solution could leave managers to focus on portfolio related activities.

Managers should consider implementing string governance, but not necessarily shadow account for:

  • Back-office processes, such as reconciliation, NAV calculation and fund statement administration.
  • Middle-office tasks, such as collateral management and some treasury services.

Separation of Duties at Small VS. Large Managers

Is there a need for a dedicated risk manager?

 

Key takeaways:

  • Large managers ($1billion+) should have a separate risk manager.
  • Multi-strategy managers should look to have a separate risk manager.
  • Small managers usually incorporate risk management under the COO.
  • Managers need to demonstrate risk management across their entire business, not just the portfolio.

Investors continue to expect that risk management be at the forefront of a manager’s business. Managers need to demonstrate this across their entire business. Managers should also understand that risk management is not just the risk statistics of their portfolio.

 

Opera Standards

 A discussion on OPERA (Open Protocol Enabling Risk Aggregation)

 

Key takeaways:

  • We agreed that OPERA is a start in the right direction towards hedge fund transparency.
  • Standardizing is not easily implemented for every hedge fund strategy.
  • Potential data issues relying entirely on administrators and managers for completion.
  • Investors need greater education on the limitations of OPERA reporting.

Risk Management System for Hedge Fund Managers

How do you select the right portfolio risk management approach for your hedge fund?

Key takeaways:

  • There are so many systems to choose from. Managers tend to use what they know best.
  • Small hedge funds use Prime Brokerage analytics but cannot aggregate across their portfolio.
  • No risk system can do every asset class.
  • Many risk system models are stale or redundant. They require a lot of user driven improvements.
  • More education is required.

Our discussion focused on the frustration that hedge fund managers have when selecting, implementing and using a portfolio risk management system. Many of our guests outlined that risk systems are expensive and don’t provide value to small hedge fund managers. We all agreed that the risk output for investors still requires further education.

 

About Kristoffer Houlihan, CQF:
Kristoffer Houlihan, CQF is Managing Partner, Armilla Partners based in Newport Beach, CA. Before founding Armilla, he was Managing Director and Chief Risk Officer for Bank of New York Mellon’s hedge fund platform. Prior to BNY Mellon, he was a Director in Risk Management for Pacific Alternative Asset Management Company (PAAMCO), a $10 Billion Fund of Hedge Funds. For more information about Armilla Partners, visit http://armillapartners.com.

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