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Risk Management Is Top of Mind for Investors and Hedge Funds

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After a good run for most in 2021, hedge funds and their investors are expecting choppy markets for the next few months. 

Investors overseeing pension and endowments, like College of the Holy Cross’s Dan Ricciardi, are making sure that the hedge funds they hire to help manage their pools of capital are managing risk as they brace for more


volatility

“It doesn’t matter how good their performance is,” he told Insider. “If they don’t have the systems in place to back that up, what’s the point?” 

General and limited partners are increasingly concerned with operational risk management, according to a recent report from the investment management firm SEI. The increased focus on operational strength is the single biggest shift over the past decade, with 14% more respondents agreeing that it is a hallmark of institutional quality than they did in 2012.

The industry had a wake-up call last year after the collapse of Archegos Capital management. Credit Suisse shut down its prime brokerage unit after suffering heavy losses and recently said it was overhauling its risk management.

Over the past few months, hedge funds have been plagued with losses and closures. Tiger Global is down 52% for the year, Bloomberg reported in June. Melvin Capital is shutting down after experiencing steep losses during the first half of the year and a 39% drop in 2021.

The investors surveyed consider operational due diligence as the area of most radical change in the years since the 2008 global financial crisis, according to the report, which surveyed 79 hedge fund managers and 81 investors.  It’s a follow-up to a survey SEI conducted 10 years ago.

For the College of the Holy Cross, which has an endowment with roughly over $1 billion in assets, operational risk management is one of the most important factors in managing the college’s capital, said Ricciardi, the associate vice president for investments and institutional resources. Ricciardi began working for the college in 2008 and saw hedge funds that were prime brokerage clients of Lehman Brothers shut down shortly after the financial crisis. 

Before the 2008 financial crisis, risk management wasn’t top of mind for hedge funds, since there weren’t as many market disruptions, said Russ Ellis, SEI’s vice president of thought leadership.

Since the crisis, hedge funds have put more of an emphasis on operational risk management. The fallout from the crisis pushed investors to become “more attuned to headline risk and demanding reassurances of robust operations,” the SEI report noted. 

“The market has evolved and it’s become more sophisticated; there’s new technology, there’s new insights and it’s actually allowing risk management, not to be one-size-fits-all,” Ellis said. 

Many investors have doubled down on operational risk management, Ricciardi noted. For some firms it became so cumbersome they started to hire third-party firms to help with operational risk management.  

During his typical due diligence process with managers, Ricciardi asks about recent operational challenges and how the manager dealt with them and how they learned from the experience. 

“I’ll ask the investment team a little bit about how they’re interacting with the operations,” he said. “I think that they can be a really key partner in dealing with unique market conditions like this.” 

Over the past month, amid the turbulent market cycle, Ricciardi has been asking managers to articulate what would happen if markets close. For example, if a manager has exposure in Hong Kong, and there was a disruption in the China A-share market, how would they be able to deal with that on an operational level.

The need for stronger operational risk management also comes as hedge funds are building more sophisticated funds and structures, said Maryann Simmons, a managing director at SEI. 

“We also see our clients moving very aggressively into the high-


net-worth

distribution channels,” she said. “And with that, a significant increase in the number of investors are coming onto their platforms. So the need for robust infrastructure and operational sophistication is becoming increasingly important.”

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