He said: “Family offices ask more probing questions of hedge fund managers because it is their money. I don’t see institutional investors asking the same detailed questions.”
Institutions, he claimed, were focusing too much on investment process and failing to find out enough about the hedge fund’s risk profile and risk control mechanisms.
A more rigorous due diligence process would, for instance, seek to understand how the manager trades.
Mr Heywood said: “Investors need to ask the hedge fund manager: ‘How do you initiate trades and scale them up and down? How do you move out of the position you have traded when the market moves against you? What experience, if any, have you of trading out of a perilous position? How would you go about it? Other key questions are: what is your capacity? And how do you justify that limit? How much open interest are you comfortable with and do you ever break that open interest rule?’”
Gleaning information on both the leverage policy and the stop/loss policy was also crucial.
“These are the questions I don’t get asked very often by institutional investors and I wonder why not?” he observed, adding that investors should continue to communicate with and monitor their hedge fund manager on a regular basis.
Large fund of hedge funds managers, he said, claimed to have the best underlying managers, the best performance, the most uncorrelated assets and the most diversified portfolio. But when it came to questioning hedge fund managers, many funds of funds neglected to focus in sufficient detail on the all-important trading questions.
However, according to a recent report by the Bank of New York (BNY), institutional investors’ ability to identify and assess hedge fund managers will “dramatically improve” over the coming years. As a result, hedge fund managers will be increasingly required to demonstrate operational excellence and comprehensive risk oversight, as well as offer fee structures that are more closely linked to value and performance.
The report shows that global institutional demand for hedge funds will increase from $360bn now to more than $1000bn by 2010. Retirement plans will be responsible for the bulk of asset flows, with corporate and public pension plans in the US accounting for the largest increase overall.
The survey, which was undertaken before the Amaranth debacle, found that potential scandals could act as a brake on predicted growth.
Claiming that institutional investors which subscribed to hedge funds were “overwhelmingly pleased with performance”, Ivan Royle, a spokesman for BNY, said that “unique and isolated” blow-ups such as at Amaranth “should be kept in perspective”.
He said institutional investors were already asking hedge fund managers about their trading policies but that “clearly” such questions needs to be broached in greater depth in the future.
As hedge fund investment became more mainstream, he added, the level of transparency would increase. But investors had to bear in mind that there would “always’ be isolated blow-ups in the industry. Mr Royle contended that such problems would have to be arising in “a sustained and systemic fashion” before investors started withdrawing en masse from hedge funds.
HS
