Managing Hedge Fund Risk

under car hoodHedge funds have grown exponentially in the pension space in recent years. A recent Towers Watson study clearly shows the flow of institutional money into the hedge fund space. In 2002, institutional investors accounted for $125 billion (USD) of hedge fund assets: by 2010 that had grown to $1.1 trillion (USD). This is a significant jump in assets, particularly in the wake of the 2008 financial crisis where hedge funds have emerged as an important risk management tool in the pension world.

Alongside with growth in the industry, plan sponsors have become far more sophisticated and knowledgeable about individual strategies and their managers. This increasing sophistication is quickly changing the way they invest: more pension funds are now moving away from the fund-of-funds approach and into direct manager selection. The move to direct investment makes sense for a number of reasons.  To start, the economics of the direct approach can be more cost effective.  At the same time, large pension funds are now more interested in customizable hedge fund strategies that will fit within their portfolios and can help offset other risks that exist across the pension fund. In addition, growing hedge fund experience and sophistication among pension funds has made it more economical and affordable for them to bring talent in-house, rather than hiring external managers.

The importance of due diligence

While direct hedge fund investment has its advantages, it also involves a host of new risks that must be understood and managed. And while plan sponsors have become very sophisticated in how they use hedge funds to mitigate the risks within their portfolios, more work needs to be done in the area of operational due diligence.

Conducting operational due diligence in the hedge fund space begins with two key questions: Does the manager or the firm have the operational capabilities to support the investment strategy? And, are their resources and managers capable of executing a strategy and running a sound business? To be certain, these questions are important during the hiring process — but are they part of a plan sponsor’s review and ongoing evaluation process? If they aren’t, then they should be.

Plan sponsors must also ensure that they have a clear understanding of the key partners involved with the manager, including the prime broker and the administrator. Due diligence in this area should focus closely on the books and records of the fund, in addition to regular auditing and ensuring investors receive timely and accurate information.

As the industry continues to evolve, plan sponsors must clearly be able to assess and understand the hedge funds they invest in. Moreover, they need to monitor them and make sure that those funds continue to deliver value while avoiding the operational risks.

Joe Morgart is Senior Vice President, Alternative Investment Strategies