Madoff 5 years later: Still a need for transparency and technology improvements

Five years ago, the massive fraud perpetrated by Bernard L. Madoff damaged the hedge fund industry's reputation and cost investors roughly $21 billion. Since then, it has become clear that independent checks — investor control of assets and transparency, in particular — could have prevented the debacle.

It's also plain that institutional investors on the whole have not yet demanded the full range of independent checks, even as their growing investment in hedge funds provides greater leverage over industry practices. Fortunately, institutional investors can bring more transparency to the relationship between investors and hedge fund managers, thanks in part to state-of-the-art technology.

Since the financial crisis, the hedge fund industry has grown by nearly $1 trillion, and institutional investors have accounted for more than 60% of the additional inflows. As a representative sample, in the last three years alone, Northern Trust institutional clients have increased their hedge fund investments by 79%. Two-thirds of that increase was driven by “mega investors” — those with more than $1 billion allocated to hedge funds. These investors have displaced high-net-worth individuals and family offices as the primary source of capital for hedge funds. With this newfound leverage, institutional investors possess the influence needed to demand additional controls and transparency for their underlying investments.

Nevertheless, investor controls and transparency remain remarkably static. Northern Trust conducted research to measure the opacity (the lack of transparency) of institutional hedge fund investments. Nine out of 10 institutional hedge fund dollars are in opaque structures with little or no transparency to underlying investments. More surprisingly, that figure has only dropped slightly post-crisis, from 94% in 2010 to 93% in September 2013 — with 100% being the most opaque.

What Institutional Investors Can Do to Improve Transparency

What can investors do to improve transparency? Typically, investor control of assets is employed via managed accounts. Assets in such accounts are controlled directly by the investor or its agent, not by the hedge fund manager. This gives the investor the ability to remove the manager, if needed. Managed accounts also offer stronger oversight, specifically with the ability to select and monitor service providers.

Although hedge fund opacity remains high, the mega investors with more than $1 billion in hedge fund investments have a hedge fund opacity rating of 85%, reflecting a potential shift towards managed accounts and the influence commanded by big ticket sizes. But these investors are learning that managed accounts alone aren't a cure-all solution. The setup of these accounts and how they're used dictate their value.

At a minimum, managed accounts should provide investors with control over the service providers and an independent verification of the assets held. Transparency, the next level of investor protection, has two critical components. First, assuming transparency is obtained, an investor needs to be able to aggregate all the position-level data across various types of investments to evaluate the risk at a portfolio level. Second, an investor needs to be able to make decisions on that information in a timely manner.

Given these demands, investment firms that have the oversight and insight to make timely investment decisions are at a competitive advantage.

Technology Can Assist

How do investment firms offer transparency and oversight quickly and accurately? Cutting-edge technology can help.

State-of-the art technology can provide institutional investors with improved transparency. Hedge fund managers with a robust, fully automated infrastructure can provide clients with a wealth of information quicker, more efficiently and customized to suit clients' needs to make informed investment decisions.

At the end of the day, however, it's still all about the data. Someone has to gather it, and investors have to see it and be able to use it. Those who gather the data must have the investment, operational and technological expertise to also synthesize it in a meaningful way for clients. Likely candidates include hedge fund of funds with access to position level transparency, administrators or custodians.

Not all data is created equal either. Although there are industry-wide efforts towards standardization afoot, such as the Open Protocol Enabling Risk Aggregation Standards, reporting and valuation are not consistent. Even the simplest equity options can be reported different ways by different managers.

Technological developments are improving the handling and processing speed of large datasets. Ideally, investors will have access to a single platform that will give them performance analysis, current exposures and risk measures for an entire portfolio, with drill-down capabilities. However, most hedge fund managers still rely on isolated, individual platforms for fund administration. Multiple platforms require reconciliation, and that adds time and potential risk to the reporting process.

The needs of institutional investors aren't unique or specific to the mega investor class. They align with those of individual investors. By placing realistic demands for transparency on fund managers and deploying technology in a smart way, institutional investors can protect their beneficiaries' assets and significantly mitigate the likelihood of future cases of fraud.

Jane Buchan is CEO of Pacific Alternative Asset Management Co., and Pete Cherecwich is chief operating officer of Northern TrustCorp.'s institutional client business.