Against the
backdrop of radical change in the landscape of hedge funds and risk management,
not to mention the advent of derivatives, the Managed Funds Association and BNY
Mellon, a global financial services company, have issued a report outlining a
number of best practices. The report noted that the SEC is poised to implement
the JOBS Act and adopt regulations removing the Regulation D ban on general
solicitation for private funds. The report said that this change could
encourage more publicly-accessible fund websites and allow fund managers to be
more candid and forthcoming when engaging with media on risk management practices and information. Moreover, the
report predicts that the erection of Dodd-Frank mandated derivatives exchanges
should spur marked improvements in the data available for exposure and risk
analysis.
The report urges
hedge funds to invest in risk management as a required business practice and
not as an optional expense. Risk management functions should be separated from
the investment and due diligence functions. The position of Chief Risk Officer
should be created with compensation that it not performance-based, recommended
the report, but that is substantial enough to provide an incentive to do the
job properly. Disclosure of risk and exposures to investors would be an
excellent way to mitigate investor concerns about investing in a hedge fund.
Risk disclosure should be granular, meaningful and frequent. Concomitantly,
investors could be educated about hedge fund risks.
Transparency has
improved, noted the report, but getting independent and high frequency reporting on
risk and exposures is still not the norm. Trusting a manager is one thing, said the
report, since trust is important to any business relationship, but validating
this relationship through position-level analytics of exposures and risk should be seen as the only prudent and
effective path going forward.
With regard to
operational risk, the report noted improvement in managing counterparty credit
risk by detailed knowledge of counterparty quality. In addition, ratings,
equity prices, credit spreads, and data integrity are more fully appreciated by
managers and investors alike. In particular, there has been recognition of the limitations
of certain risk and industry assumptions. The research indicated that
diversification is being used as the best method to mitigate counterparty risk,
since the financial condition of a counterparty can seemingly change virtually
overnight. Manager’s intentions are to
avoid high concentrations in a single counterparty since few believe that any institution
is immune from periods of systemic and non-systemic volatility, contagion, and
risk. There are some instances where managers and investors may seek to hedge
counterparty risk with derivatives.