Institutions Push Hedge Funds Toward Better Practices

By Maria Trombly | Securities Industry News | January 1, 2006

The California Public Employees' Retirement System (Calpers) has $2 billion to invest in hedge funds and has already invested $1 billion of that. Calpers is not alone in putting significant chunks of cash into hedge funds. This year, State Street Corp. released the results of a survey of institutional investors with total investable assets of more than $1.2 trillion. One-third of respondents had at least 10 percent of their portfolios invested in hedge funds, while half intend to have 10 percent or more invested in alternative strategies by 2007.

If you're a hedge fund that wants this money, you have to run a tight ship--and be willing to show visitors around. For example, pension funds may demand--and get--more reporting and tighter controls than required by SEC regulations. "We run a conservative program and demand compliance and transparency," says Calpers spokesperson Brad Pacheco. To help ensure that its investments are well taken care of, Calpers uses the services of outside consultant UBS Brinson, which helps with reporting and due diligence, Pacheco says.

Another level of oversight comes from the fact that $500 million of Calpers' $2 billion investment pot is earmarked for funds of hedge funds. Funds of funds are more costly for investors than ordinary hedge funds, but with the extra cost comes a certain amount of due diligence and supervision.

According to recent in-depth interviews of nine institutional investors by public and investor research firm Cubitt Jacobs & Prosek, based in Stratford, Conn., price was less important than transparency. "The overwhelming response--if not unanimous then damn close--is that they would take full transparency with the lesser returns," says Thomas Rozycki, head of the firm's investor relations practice.

SEI Investments Global Funds Services has 32 hedge funds within its fund of funds, says John Diederich, SEI's portfolio manager for institutional clients. "We're able to serve as a fiduciary for the pension plans and provide oversight of multi-strategy hedge fund vehicles," he says. The involvement of institutional investors has increased transparency, compliance and operational controls in the hedge fund industry, he adds.

"Institutional investors have a somewhat higher need for more detailed information overall, particularly regarding operational and compliance-related issues," confirms Reid Bernstein, CEO of OneCapital Management, a New York-based hedge fund and fund of funds manager. "That does have a carryover impact to funds of hedge funds that wish to serve those types of institutional investors."

Other institutional investors hire private firms to handle some of the investigative work. For example, Vance International vets dozens of hedge funds a year for institutional investors. "In recent years, it's really picked up based on the exponential growth of the industry," says Chris Marquet, senior managing director in the firm's Boston office. Marquet says he goes beyond looking for transparency and a robust compliance program and audit capabilities. For instance, clients will hire him to look into the backgrounds of new managers that hedge funds hire.

As a result of these demands, hedge funds are starting to spend serious money on compliance technology. For example, PA Consulting Group has recently helped hedge funds implement risk management and trading systems normally used by the largest broker-dealers. "These are large, well-known packages that the hedge funds would normally never invest in," says Peter Stockman, a member of PA Consulting's management group. "These are on the order of $2 million. The main reason is transparency. They have to be able to do much more rigorous risk reporting than they have in the past."

One hedge fund that he's worked with has ten investment professionals on staff and hasn't even begun trading yet--but it's already installed a package from Calypso, one of the most expensive systems on the market. Other funds trading energy products are installing OpenLink and TriplePoint, Stockman says.

Institutional investors also have the expertise to follow up, says William Tueting, a partner at Chapman & Cutler LLP. "Institutional investors often have finance people on staff and have been investing in various assets for years," he says. "They know which questions to ask."

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