They are also rewriting some of the ground rules of capitalism. The Financial Times newspaper recently quoted a banking source as saying the enormous clout that comes from hedge funds having $1.4 trillion under management at the end of 2006 makes them the "new JP Morgans."
For instance, although hedge funds own just 1.5% percent of global assets, they account for more than half of US bond trading, 40% of US equity trading, and 80% of distressed debt trading, according to the FT. Hedge funds' influence extends far beyond mere numbers, of course, because many have assumed the role of shareholder activist, influencing the corporate governance of companies ranging from Blockbuster to Wendy's International to H.J. Heinz. Much as the actions of JP Morgan and his fellow financial titans did a century ago, the investment decisions of hedge fund managers reverberate throughout the U.S. financial system.
Tales of hedge fund blowups tied to aggressive investment strategies that are concentrated and highly leveraged are well known. But, in fact, the data indicate that mundane, nonmarket risksùbetter known as operational risksùcould pose just as large a threat to hedge fund investors as exotic investing strategies. There isn't always a bright line distinction between investment and operational risks because they are often interrelated. But one indisputable difference is that operational risk is uncompensated risk. In the hedge fund industry, it's even known as silent risk because most institutional investors have little or no awareness of the operational differences among hedge funds. As such, they typically don't factor operational risk into their risk/reward considerations.
Standard & Poor's Ratings Services thinks more should be done to raise awareness of operational risk. A good first step is an introduction to 10 common operational risks that hedge funds face. But first, a little background on why operational risk in hedge funds is more important than one might think.
Operational risks can be found throughout the enterprise
Operational risks can be found anywhere from back-office IT systems to controls intended to mitigate the probability of rogue trader losses. Some of a hedge fund's greatest exposures typically reside in aspects of the business such as staffing, technology infrastructure, regulatory compliance, legal issues, trade processing, accounting, fund administration, and valuation.
A March 2003 study by Capital Markets Co. (Capco) found that operational issues account for a relatively high proportion of hedge fund closures and that better due diligence and monitoring practices are key to detecting risk factors. Moreover, Capco says in the two decades prior to 2002, 54% of all funds that failed because of fraud suffered from operational problems, some of the most common being:
- Failure to prevent the misrepresentation of fund investments.
- Misappropriation of investor funds.
- Unauthorized trading.
- Inadequate resources to run the fund efficiently.
Most recently, operational risk has come to the forefront with the alleged frauds at Bayou Management and Wood River Capital Management as well as at Amaranth Advisors. Obviously, Amaranth assumed market risk with the natural gas positions it held, but it also took a risk that it might not be able to unwind these holdings if it had to sell quickly, which is exactly what happened. In our view, this is a classic example of instrument liquidity risk, which we characterize as an operational risk.
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