Hedge fund assets under management have soared 21 per cent this year, to $1300bn (€1015bn), according to Hedge Fund Research. Big Wall Street banks are jockeying for a piece of this expanding sector, which is increasingly seen not as another asset class but as another asset management style to run alongside their traditional fund management businesses. Last month, for instance, Morgan Stanley announced three hedge fund deals in just three days – the purchase of FrontPoint Partners, and alliances with Avenue Capital and Lansdowne Partners.
At the same time, hedge fund investors are also becoming more institutional, and picking up the level of their due diligence. “The whole hedge fund administration space is changing rapidly,” says Bhagesh Malde, global head of JPMorgan Hedge Fund Services. “The hedge fund industry grew up quickly and saw no need to focus on quality, but funds now are more discriminating in their choice of administrator.”
Service providers are scrutinised much more closely in terms of their IT platform, operations and the experience of their staff. Recent blow-ups like Archeus Capital, whose administrators GlobeOp may even be sued for its failings, have created a huge political backlash that does not help. Nor do embarrassments such as Beacon Hill, which demonstrate that even the most sophisticated alternative investment firms can apparently fail to detect possible fraud.
“The greater involvement of institutional investors has created more pressure on investment transparency,” agrees Dermot Butler, chairman at Custom House Administration. “Issues of security and controls worry institutional investors more than high-net-worth investors who very often have forged a personal relationship with the fund manager.” All told, a $1 lost for every $250 invested in hedge funds remains a good yardstick for the level of fraud. “People don’t care if a flower shop or a restaurant fails because these kinds of new businesses fail all the time, but a hedge fund failing is big news for the media,” adds Mr Butler.
The push for transparency has also been driven by a greater urge among institutional investors to pinpoint what portion of a fund’s return is being derived from alpha and what from beta, so that the risk/reward profile of their portfolios can be understood and engineered more accurately. This is far from simple for structured products linked to a basket of diverse assets, for example, which are perhaps the fastest growing new instruments, particularly for managers who feel they missed some of the commodity boom. Very exotic options that include both FX and interest rate protection are also popular in the corporate market for multi-nationals looking to hedge both these risks with a single product.
Fogged transparency
Transparency in valuing funds of hedge funds remains difficult. As these funds target the retail marketplace, daily reporting is becoming more commonplace. Mr Malde estimates that only around 5 per cent of administrators currently offer daily valuations but expects that number to double every year as service providers update their platforms. Clearly, this level of processing is time-consuming for the service providers; one master fund based on 30 funds requiring daily valuations must generate 600 valuations per month.
Risk management will attract the full glare of the spotlights if there are any more blow-ups like Amaranth that on the face of it were caused by poor risk assessment. Forensic and investigatory work is also growing, but based not on an increased incidence of problems, but on the sheer expansion of the universe.
There is also the push to more robust operational risk assessment, and growth around putting processes in place ready for MiFID (Markets in Financial Instruments Directive), which focuses on driving transparency into the trading arena and takes effect from November 2007, and the EU Capital Requirements Directive (CRD) due to come into effect in January.
“In Dublin, recent change in Irish Stock Exchange rules requiring administrators to periodically verify and reconcile OTC positions in certain situations has caused much head scratching among the administration community,” says Brian Forrester, a partner at Kinetic Partners. “No prescriptive guidance has been given as to the specific nature of the verification and administrators are currently working through their existing capabilities to assess their ability to meet the new requirements”.
Service has become a competitive differentiator, while price sensitivity is relatively low. “Clients are more willing to move with their feet and change service providers and pay more for better quality, but it’s one-way traffic,” says Mr Malde. “No-one would make a transition to a small group, though they might start with a small group and grow up with them.”
Passing on the costs of dealing with these additional complexities is not terribly easy, either. “The number of new entrants has kept fees keen,” adds Mr Forrester. “There have been half a dozen new entrants to Dublin in recent months, all with their own USPs and they all want their piece of the action. Service level agreements (SLAs) can be used to provide a rationale to increase charges, but SLAs have also been used in the past to apportion blame. People are a little nervous of using them except for their largest clients.”
As the hedge fund universe expands, retaining experienced staff is one of the industry’s major challenges, never mind the jurisdiction. Firms are trying to deal with the customer relationship problems this creates in several ways. At Quintillion, a new operation set up by former PFPC staff in Dublin, staff with service of five years will receive options.
UBS operates a single point of contact model for clients rather than an array of contacts, one for each function. This also aids staff retention at UBS, according to Colleen Montain, head of global business development, because each individual has a more varied and challenging role with primary responsibility across all functions.
Draining the coffers
The challenge of maintaining leading edge IT is also a real one, creating a continual drain on the coffers year after year. Top-tier administrators usually have a proprietary solution at their core, notably portfolio accounting and reporting software Advent Geneva and share registration system Koger Ntas.
 | Gershon: it will take a crisis to produce a clear guide for pricing options |
However, David Gershon, chief executive of option pricing, risk management and independent revaluation firm SuperDerivatives, says that no-one should underestimate the dangers of running with hedge fund administrators who have inadequate systems and are not themselves familiar with some of the complex products. One fund administrator, he says, is run by a group of young graduates fresh from university, who download programmes off the internet, but have no experience of trading derivatives. They “do not come close to fair market price”, Mr Gershon says.
“We have a vision that the world of options will be transparent,” he says. He likens the current scenario to a world where, to use a used car analogy, there is no standard book price. It will take a crisis, he suggests, to produce a Blue Book or Glass’s Guide for options, so like can be compared with like.
Large firms are not interested in hedge funds of $100m. Darren Stainrod, head of fund services at UBS in the Cayman Islands, says that as larger players consolidate, some of the bigger players are at capacity restraint, and some set their minima as high as £500m-£1bn. However, 70 per cent of hedge funds are reckoned to have less than $100m in assets, creating opportunities for smaller firms to enter the market, and as they get bigger, the small firms grow in tandem.
HOW TO TELL IF THE PRICE IS RIGHT
The development of increasingly sophisticated products, along with a greater preponderance of hard-to-value instruments like catastrophe bonds, energy and distressed debt is a constant challenge for administrators, particularly at a time when the trend is towards immediate transparency and risk management.
The majority of administrators use pricing agents such as Lombard Risk, SuperDerivatives and Mark-It Partners, and will have a system of calling in a third party if the issuer and outside source disagree by more than a nominal percentage, such as 2 per cent.
Some firms such as Bisys have also created a specialist team to deal with difficult markets; in its case, a high incidence of credit default swaps, carbon emissions, freight and shipping derivatives.
“To me, the biggest problem in revaluation is to obtain accuracy pricing for derivative portfolios,” says David Gershon, chief executive of SuperDerivatives. “The problem is model dependant. People think it’s a subjective question, but it’s very objective. The numbers should be consistent. It should not be a case of taking a pile of models and rates and putting them all in a soup with a portfolio of derivatives in order to get some value. The issue is not to get a number but to get the right number, the fair value of the portfolio that really reflects that value of the derivatives in the inter-bank market.”
Mr Gershon cites the example of MotherRock, a hedge fund that lost money through its investments in natural gas, and was subsequently bought by Amaranth. “When MotherRock’s loss was first announced, ABN Amro estimated it at between $75m-$150m. There’s a big difference between those numbers,” points out Mr Gershon. “People may ask: ‘How is it possible that a great bank like that does not know the exact number?’”
ABN Amro was probably aware that the exchange’s settlement prices they’d used for valuation could be significantly different than the real market price, explains Mr Gershon. And when they hired SuperDerivatives to revalue the portfolio it showed that the difference to MotherRock’s fair value was in tens of millions of dollars.
“If we’d done the same exercise on Amaranth”, adds Mr Gershon, “the difference in book value would probably have been $500m.”
The trend to verify prices using specialist firms is partly a result of demand for greater professionalism as the market becomes more institutional. “Clients want to compare hedge funds and get an accurate picture, but the numbers depends on their revaluation methodology and may present quite the wrong picture,” adds Mr Gershon. “Only one thing provides an accurate valuation and that is the price if the portfolio was to be taken to market and valued at market rate. The only way to compare valuations is to use the same methodology.”
Greater recourse to specialists is also a response to high profile blow-ups that demonstrate fraud can be identified at a much earlier stage if the valuer really understands the product. For instance, 70 per cent of the loss at the National Australia Bank fraud in 2004 stemmed from the revaluation process, according to KPMG. Four managers, who are now languishing in jail, had created a completely fictitious P&L, based on the Black Scholes model, which was completely off market price. A specialist service would have picked up the wrong-doing on day one.
Nevertheless, experience shows that administrators come to grips with new products fairly rapidly. Research by the Alternative Investment Management Association (AIMA) suggests that 14 per cent of assets under management were considered hard-to-value instruments two years ago, but products that were then considered hard-to-value are now considered routine.
