Ponzi schemes once plagued only individual investors. Now pension funds and other institutional investors are catching this disease all too often. With some prudent transparency, this need not have happened in the institutional market. Now many institutions might be tempted to disallow hedge fund investments altogether, when what is really needed is effective transparency and risk management.
For their publicly traded long-only strategies, institutional investors long have hired their own custodial service. For hedge fund strategies, investors should have been hiring their own prime brokers and forcing their hedge fund asset managers to work through them.
By hiring their own prime broker, institutional funds achieve important oversight, such as in:
• Managing agency issues. The prime broker is beholden to the institutional investor, not the hedge fund. Prime brokers would quickly learn to watch out for the interests of their client, who becomes the institutional fund investor, as opposed to their current client, the hedge fund. This mitigates cheerleading conferences for hedge fund strategies and negates potential bias by the prime broker to allow such practices as return smoothing.
• Obtaining transparency. Some hedge fund managers dont want disclosure. But most hedge fund end investments are not terribly innovative in and of themselves (and if they are be careful!) or revealing of the strategy employed. Few institutional funds are interested in replicating hedge fund strategies themselves and dont need to report real-time position information to outside entities. The tremendous demand for hedge funds has meant they can insist on opacity. That seller power is changing. In any case, hedge funds soon will likely be required to file investment adviser ADVs and quarterly 13F position reports with the Securities and Exchange Commission. For those hedge funds that dont work with the institutional funds prime broker the investor might decide it simply cannot work with such hedge funds. Does that mean selection bias weeds out the best funds? If a hedge fund has invented a money machine why does it need to manage the funds of others?
• Aggregating risk management. Institutional investors can build, buy or hire their own aggregated portfolio risk systems. They can know what their current positions look like at the fund but also for the aggregate portfolio. They can manage undesired aggregate portfolio exposures in numerous different ways. Funds of funds havent always provided real-time position reports to institutional investors and themselves dont hire prime brokers.
• Aggregating pricing. Institutional investors that hire hedge funds are typically much larger and have larger alternatives allocations than individual hedge fund managers and can obtain the same or even better prime brokerage pricing.
When I was CIO at a pension fund, we conducted among the first RFI and hire for prime brokerage services (we might have been the first, but I do not know). We then hired a basket of market-neutral strategies and, as a condition of hire, insisted that these managers work with our retained prime broker. Because prime brokers thought the industry was moving to the business model where the institutional investors retained the prime broker and not the hedge fund, the prime brokers were very aggressive in bidding for business. Perhaps the business can now move to this model.
Robert Snigaroff is president and chief investment officer of Denali Advisors LLC, La Jolla, Calif.