Over the past 20 years the investment management industry, and specifically hedge funds, has achieved tremendous growth. As assets under management increased, so did diversification in strategies and investments. During that time investors have become very sophisticated in their selection of investments as well as the operational due diligence process. This growth and sophistication has reinforced the critical role of operational executives, and their teams’ responsibility to effectively manage the operational infrastructure. These are the people, functions and technology that are an integral part of keeping these firms thriving.

Operational Excellence For Hedge Funds and Asset Managers

Achieving operational excellence for hedge funds and asset managers has never been more important. This white paper is intended to provide a useful framework and guide for all Investment Management Firms. Over the past 20 years the investment management industry, and specifically hedge funds, has achieved tremendous growth. As assets under management increased, so did diversification in strategies and investments. During that time investors have become very sophisticated in their selection of investments as well as the operational due diligence process. This growth and sophistication has reinforced the critical role of operational executives, and their teams’ responsibility to effectively manage the operational infrastructure. These are the people, functions and technology that are an integral part of keeping these firms thriving.

The challenge today is to find the proper mix of what to manage in-house and what to outsource. However, regardless of where these tasks are performed, the responsibility of their accuracy remains with the hedge fund manager. Additionally, the overall demands, including greater transparency from regulators and investors alike, are at an all-time high. Also at an alltime high is the breadth of responsibilities and the amount of tasks the operations group needs to perform.

Commandment #1: Develop a high quality legal framework and compliance program

Legal and compliance programs should be well articulated and robust in order to protect both Investment Managers (manager) and investors throughout the life of the fund. There are several key components to these programs. Legal documentation and structure vary based on a fund’s domicile, strategy, and investors.

Even a high quality legal framework with a robust compliance program is only as good as the management team enforcing it. Compliance should be a priority at the senior management level. It should be clearly and regularly communicated throughout the firm in order to properly protect investors and the firm from violations or more critical consequences.

Commandment #2: Build a great team

It is paramount that Investment Managers build a great team, starting with a foundation of trust. This consideration to quality and trust must be present both externally (between managers and investors, and also service providers) as well as internally (within the manager’s team). A strong and trustworthy team results in confidence, efficiency, and success.

The managers should work together with service providers to form an effective team. If all members of the team are working cohesively towards a common goal, investors will gain confidence in a manager’s ability to handle operational risks. However, incompetence by team members or undisclosed conflicts can lead to a breakdown in trust and potentially cause catastrophic losses. Building a great team and performing the proper background checks are effective forms of leadership that enable investors and managers to better concentrate on generating positive investment returns.

Commandment #3: Instill a culture of integrity

A culture of integrity must begin with senior management. Today, investors and managers alike are realizing the importance of disclosure and transparency above just the generation of alpha. In order to retain investors and attract new capital, managers must be able to demonstrate efforts toward instilling a culture of integrity. To be effective, integrity must be clearly communicated and backed up with a defined and obvious approach to enforcement. The culture should extend beyond just the issue of fraud, and should include a pursuit of excellence and a commitment to protect against errors and inaccuracies.

Commandment #4: Establish strong controls, procedures, checks and balances

Developing effective internal controls, well defined procedures, and sufficient redundancy for critical processes all lead directly to a manager’s operational stability and success. A well-defined organizational structure and workflow promoting straight-through processing will do wonders not only in terms of efficiency, but also in minimizing operational risks.

When developing a system of checks and balances, managers should view most processes in terms of calendar events with deadlines clearly communicated to the necessary personnel. This organized workflow will lead to a more efficient operation and should reduce the probability of fraud by keeping tight procedures for completing tasks, on a strict schedule. Errors and omissions will become apparent when the proper personnel and systems are engaged at the right time, making any inconsistencies obvious.

Commandment #5: Ensure proper separation of duties

An essential element to operational safeguards is to establish a clear separation between the investment team and the operational functions of the firm. This type of separation can assist with establishing trust between managers and investors. It also sends a clear message to employees that management is dedicated to the integrity of the firm.

Considerations should include arms-length transactions with service providers. While strong relationships are important and should be fostered, conflicts can arise when services are provided at the expense of investors. Trading with an executing broker who is a family member or close friend who does not offer the highest level of service, or an attractive price, presents a clear conflict of interest. For many managers, it is helpful to solicit bids from service providers on a regular basis in order to ensure that the current arrangement is competitive. Disclosing these types of procedures is another way that managers can prove to investors that they take conflicts of interest seriously and are providing the best service possible to their clients. From an investor’s perspective, any comprehensive due diligence process should look closely at arrangements between service providers.

Commandment #6: Don’t ignore red flags

In the world of Investment Management operations, even a minor mistake should be investigated. Small discrepancies can eventually become large operational risks, and individual issues can often be an indicator of much larger fundamental problems. Mistakes which are caused by a lack of control and procedure need heavy emphasis. When dealing with a red flag, or potentially risky behavior, management must determine exactly what the potential consequences are. Operational risk can often be quantified to allow management to place an appropriate price tag on the instance and determine the resources necessary to reduce or eliminate the risk. However, the red flag which can pose the greatest danger is one which results in a small loss which masks a major operational flaw.

Commandment #7: Develop competent technology and a business continuity plan

A properly organized and stable technology framework is the backbone of a firm’s operational infrastructure. Whether the technology is managed in-house, outsourced, or a combination of both, continued stability and security is vital to the integrity of a firm’s data and its ongoing operations. The technology structure of every investment firm should have two primary goals:

1. The first goal is to ensure that the firm remains operational throughout a myriad of extraordinary events such as power failure, systems breakdowns, and extremely high volume. This allows portfolio managers to execute trades, manage risk, and properly protect against investment losses and to capitalize on opportunities even during chaotic situations.
2. The second goal is to protect the integrity and security of the firm’s data. Issues such as natural disasters, internal or external theft, corrupted data, or incidental publication of private fund or customer data can all compromise data protection. Risks associated with the integrity of the firm’s data can range from inefficient operations and missing documentation, all the way to criminal negligence and the potential closure of the firm.

Commandment #8: Define the valuation and NAV process

The independence of pricing and NAV calculations is one of the most important issues investors face today. Pricing and NAV calculations can be some of the most widely disputed processes within any firm trading less than liquid assets. In order to establish and maintain a reputation of integrity, managers should always allow the NAV to be calculated or validated by an independent administrator. At the same time, each manager should prepare their own internal calculation of the NAV. The two accounting processes should be compared in order to determine the accuracy of the third party administrator.

Commandment #9: Demonstrate strong oversight with a clear chain of command

Many Investment managers operate as relatively flat line organizations. Personal responsibility can be a powerful motivator and each employee should be empowered with the understanding that he or she makes a difference in helping to build and strengthen the firm. There should be accountability at every level and a very clear chain of command in place.

Commandment #10: Reconcile, reconcile, reconcile

Although this may sound overstated, reconciliations may be one of a manager’s best defenses against fraud, errors and loss of reputation due to NAV misrepresentation. All of these events can be detrimental to a manager’s success. On a daily basis, managers should perform cash and position reconciliations to help to prevent such issues as duplicate or unconfirmed trades, oversized (or undersized) positions, and duplicate or missing cash transactions. Furthermore, there are various daily, weekly and monthly reconciliations that keep the manager’s data updated and accurate. These may include: valuations, collateral management, subscriptions and redemptions, fees and expenses, as well as unencumbered cash and various treasury functions.

What are your 'ten commandments?'  – let me know in the comments.

This article is an extract from the full whitepaper by Frank Caccio. The full version can be downloaded below.