Tough Minded Investment Manager Analysis

Do Hedge Fund Managers Understand Operational Risk?

Ernst & Young recently published a survey of some 100 hedge fund managers’ views on the challenges facing their industry.  When asked, “On a scale of 1-10, how big a challenge will the following be in the next ten months?”  Managing operational risk came in a poor third after attracting and retaining talent and managing the growth of the business.  18% of the managers in the survey gave it a rank of 8, 9 or 10.  In terms of relative importance, the industry gave the right answer.  But considering how frequently operational risks kill hedge funds, the industry’s answer gives no comfort at all.

When Ernst and Young’s survey firm asked hedge fund managers, “What do you see as the main source of operational risk over the next two years?” managers replied, “Not having the right people” 18%, “Valuation/pricing risks” 16%, “Complexity of new products and strategies” 14%,”Compliance with regulatory changes” 14%, “Inadequate technology” 13%, “Increased trading volume” 12%, “Not having the right infrastructure in place” 11%,  “Human error” 7%.  How reasonable those answers are depends on what you consider operational risk to be and what you mean by those answers, I suppose.  The percentage replies above only make sense to me if we take a narrow view of operational risk.  If we assume that fraud is not an operational risk, for example, the answers above make some sense.  But if we assume, as many in the industry do, that operational risk is all risk without reward, then the answers make no sense.  If we assume that fraud is of some importance, then the single most important operational issue is making sure that you have the right infrastructure in place, making sure that the people who trade have no say in valuing the assets, for example.  After that, in my opinion, comes valuation/pricing risk.  Chris Addy, who has more experience in this area than I do, would argue that I have my priorities wrong.  Chris Addy argues that many more than 16% of hedge fund managers have valuation problems.  He is right, of course, and this is something that investors need to worry about.

When Ernst and Young’s survey firm asked hedge fund managers, “What steps will your organization be taking to improve the management of its operational risks?”  Managers replied, “Hire more of the right people” 34%, “Invest in technology” 24%,  “Improve or institutionalize policies and procedures” 16%, “Bring in outside expertise” 11%, “Review control processes” 11%, “None necessary” 9%.  I take considerable comfort in the fact that the only 9% of the respondents answered, “None necessary.”  Twenty years ago the answer would have been 90 or 95% or more.  And no, I am not joking about those percentages.

On the other hand, on the glass is half empty side, the percentages here are all too low.   It suggests to me that all too many hedge fund managers are naive or deluded.  This may not be true about the hedge fund managers you work with, but unless you know for sure, I suggest that you assume naive or deluded or both.

The only way to get a solid answer is an operational audit, of course.  But that’s expensive.  A cheaper approach, an approach to use early in the due diligence process, is to ask the manager what he sees as his operational risk problems and why.  Compare his answers with what you know about how he manages operational risk and with what you know about the state of the art.  If his answers make no sense and that will often be the case, well, then you know what to do. 

But even if his answers make sense, that does not mean he’s not lying to you.  Try to find out how much time and money he is spending and planning to spend managing these issues.  If he doesn’t have these issues under control and he isn’t putting much time or money into fixing them, then he is just another disaster waiting to happen.