How to Help Investors Sleep Well at Night

80613164The financial crisis of 2007-2009 led to enormous losses of wealth with U.S. households alone having lost $13 trillion from the collapse of asset prices. It accelerated the contraction of the investment management industry that has been taking place since 2000. And it exposed long-perpetrated frauds such as Bernard Madoff’s Ponzi scheme, which undermined the confidence of investors to the integrity of even the most reputable managers. For certain investors, the foremost concern in selecting a hedge fund is no longer a stellar investment performance record but whether they can believe the figures they see in statements of accounts holding their assets. This is what these investors emphasize when doing their homework on the managers eventually entrusted with their money, in a process known as “operational due diligence.”

For managers, it has become an extra burden to prove their integrity to investors, which takes time away from their main task, and core competency: to deliver solid investment returns. A study of industrywide best practices shows that managers can make sizable investments in technology and talent and still have a rather ineffective operational infrastructure and control environment, which does not make the grade with the most sophisticated investors, who are typically those with the largest amounts to invest.

A typical failure in that respect is the false sense of security created by a framework based on a mechanical “check-the-box” mentality. Smart but malevolent operators can game this system—for example, portfolio managers determined to make their performance look good by manipulating asset valuations.

Having signed up a “Big Four” auditing firm is becoming another prerequisite for hedge funds that aspire to greatness, but it is of little help when the firm sends to that shop a first-year staff auditor right out of college.

The best solution to the above problem is a healthy culture, which distributes risk management and accountability at all levels and parts of the organization, encourages the asking of tough questions and rejects deferential “yesmanship.” Add to that a strong governance structure to uphold and sustain that culture. Elements of robust governance are, among others, board independence and a truly independent internal audit function that reports directly to the board, which can strengthen the governance process and lend credence to it.

Obtaining information about operational and control best practices (freely available on the Web) is straightforward, but putting them into practice effectively is often a function of experience, investment and a robust principle-based governance structure, which will help ensure that appropriate parties are held accountable for critical activities and processes and that communication between essential functions across the firm proceeds smoothly.

Editor’s note: This is a summary from a book chapter, “A best practices framework for operational infrastructure and controls in asset management,” edited by Prof. Mike Pinedo of New York University Leonard N. Stern School of Business. The second edition of the book will be published by McMillan. 

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