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.