14/03/2010 Author: Charlie Woolnough

Comment: Charlie Woolnough

The funds of hedge fund (FoHFs) industry has seen something of a resurgence over the past few months, with performance and asset figures suggesting that the sector is well on the way to recovery. FoHFs experienced greater difficulties than the single manager industry over the crisis period; poor performance of underlying hedge funds in 2008, coupled with operational challenges resulting from gating, side-pocketing and locking-up of investor capital, have caused significant reputational problems for many firms.

While it is argued that the depth and scale of the turmoil in financial markets was difficult to predict and hence resulted in wide-scale losses by the vast majority of market participants, operational shortcomings revealed that a significant minority of players failed to attach a great deal of importance to their controls and processes. As a result, these managers have been more severely punished by investor redemptions. It is clear that many investors will forgive one year of poor performance, but will not forgive operational failure.

Extensive due diligence of single manager hedge funds has now become par for the course, but surprisingly for FoHFs, it has often been overlooked in the past. Not so anymore. Unfortunately, the apparent simplicity of the FoHF operating model has resulted in some managers failing to develop robust operational infrastructures. This is now changing as a result of investor demand.

The knee-jerk response of some investors has been to flock to managed account-type vehicles, which on the surface appear to offer obvious solutions to some of the major issues such as liquidity and transparency, but many others have come to realise that the additional cost and operational complexities render the entire process uneconomical. For most hedge fund investors, managed accounts do not offer a viable alternative way to invest in the industry. Perhaps the easier, cheaper and more sustainable way is for an investor to utilise the experience and processes that are already present and being used by the most professional FoHF players.

Of course, appointing reputable accountants, administrators, custodians and lawyers that have particular experience and skill in the alternative asset management industry would be the most logical first steps to improving operational standards. Indeed, by communicating developments that they see in the industry and encouraging best practice, these counterparties are often able to add more value than simply undertaking their respective roles.

Less well known is the fact that some administrators and/or custodians can now offer more specialised services, such as: cash management, liquidity forecasting, trade monitoring and, of course, bridge financing. Further tools to help FoHFs with the analysis of their investments and the associated risks, as well as secure online trading, are available through integrated service providers such as PFS.

Many of our value-added services have been developed in conjunction with industry participants, some of whom have invested heavily in their operating infrastructures over a long period of time. Managers that do not have the resources to develop sophisticated systems to analyse and control operations can and should utilise the offerings of their service providers if they are to remain competitive when building their own asset base.

Performance has never been the only factor that investors consider when allocating capital. Indeed, after 2008 and 2009, it has now become just one of several headline factors, along with operational controls and liquidity management.

At PFS, we strongly believe in the sustainability of the FoHF model. This belief results from an appreciation of the value that a FoHF manager adds to its investors. The majority of FoHF managers that we deal with exhibit an excellent understanding of the risk, rewards and characteristics of hedge fund strategies. Most are also able to judge the intricacies of operational risk that are naturally found within entrepreneurial industries such as hedge fund management. However, a small minority still lack the significant commitment to managing their own operational risk to the level that investors now require.

The new generation of services that administrators and custodians are able to provide managers should provide significant assistance in enhancing the management of FoHFs portfolios, ultimately helping them to improve their proposition to prospective investors.

Charlie Woolnough is regional director, sales & relationship management, at Fortis Prime Fund Solutions (PFS)