PROSPECTS OF HEDGE FUNDS AND THEIR REQUIRED OPERATIONAL RISKS CONTROLS IN PAKISTAN

SYED ALAMDAR ALI
Hailey College of Banking & Finance Lahore
Sep 03 - 09, 2007

Pakistani Stock Markets have traditionally been highly volatile. Various studies have been taken at formal and informal levels to look into the causes of these volatilities and the one major cause noted in all of the studies is of badla transactions. Whatever might be the reasons of excessive volatility, no one can deny that it has led to systematic problems, market manipulation, and investor losses. One of the patent reasons for such high volatility is the lack of hedging instruments that could protect the investors both the investors and the individual. Accordingly, in a report submitted to the SECP titled "Report on the Feasibility of Exchange Traded Derivatives Market in Pakistan" in February 2006 the recommending committee submitted that there is an undeniable need for derivative products that provide:

•Down side protection to investors

•Efficient and temporally stable price discovery, and

•Reduced dependence on CFS (modified badla) as the only source of leverage in the market.

In view of the experience in other developing markets cited above, and the current shortcomings of CFS as the sole source of leverage finance; there is reason to believe that initiating exchange traded derivatives will channel high risk capital to these markets and also attract more players and foreign direct investment capital, while simultaneously dampening volatility in the primary market.

Profile of Derivative Market: Derivative markets whether OTC or exchange-traded, provide a platform for the trading of risks. These markets exist to facilitate the transfer of market risk from individuals or institutions that wish to avoid such risks to other more willing or better equipped to manage them. Accordingly, in order for a derivatives market to serve its purpose, it is essential to have a variegated mix of market participants. In the US, Europe, Japan, and many developing countries, derivative instruments are utilized by a broad spectrum of market players with varying investment horizons and risk preferences. As regards derivative market instruments, Individual investors prefer options because of their gearing features for limited investment. Institutional investors incorporate derivatives in their asset allocation strategy for portfolio insurance. Corporate treasurers utilize derivatives for both hedging exposures and for enhancing yields. Banks and other financial intermediaries at the institutional level are attracted to these instruments for their strategic risk management features. Desk and floor traders employed by these financial intermediaries use derivatives to speculate, hedge speculative positions, and to capitalize on superior market information. Mutual funds employ them to enhance investment performance. Hedge funds use derivatives to offer products with high leverage and high expected returns. Portfolio managers utilize options to add attractive return characteristics to passively managed portfolios. Farmers secure prices by selling future contracts against their produce and users of such produce hedge against fluctuation in price.

Hedge funds are a type of product that is at its introductory stages in Pakistan. At present there is not a single Hedge Fund listed on the Karachi Stock Exchange but it is included in the list of eligible financial product to be traded in the report as referred hereinabove. Apart from making hedge fund eligible to be traded on KSE the Government of Pakistan has decided to access international capital markets for meeting its external financing needs. Private equity and debt funds, hedge funds, pension funds, mutual funds and other investors can earn an above-average return by investing in Pakistani paper while being assured of safety and liquidity of their investment.

As hedge funds are very highly leveraged financial instruments, therefore it requires specialized knowledge and skills on the part of investors and brokers to avoid any assumption of undue risk. Keeping in view the increased monitoring requirements Standard & Poor's Ratings Services have made concrete steps towards reducing the risks in such instruments. Mr. Mike Brewster at the Rating service thinks more should be done to raise awareness of operational risk. A good first step is an introduction to 10 common operational risks that hedge funds face. These operational risks are based upon chronologically tracking the hedge fund market. But first, a little background on why operational risk in hedge funds is more important than one might think.

A March 2003 study by Capital Markets Co. (Capco) found that operational issues account for a relatively high proportion of hedge fund closures and that better due diligence and monitoring practices are key to detecting risk factors. Moreover, Capco says in the two decades prior to 2002, 54% of all funds that failed because of fraud suffered from operational problems, some of the most common being:

*Failure to prevent the misrepresentation of fund investments.

*Misappropriation of investor funds.

*Unauthorized trading.

*Inadequate resources to run the fund efficiently.

The ten operational risks have been summarized hereunder:

1. CONCENTRATION OF STRATEGY IN JUST ONE OR TWO HEDGE FUND MANAGERS: Investing in a hedge fund really means investing in the general partner or partners who run that hedge fund. Because hedge strategies can be both opaque and complex, the investor is betting on management to a much greater degree than in traditional fund investing. The best run hedge funds use proven risk-management practices designed to reduce the influence of one or two top managers, like sign-off procedures for taking large investment positions, segregation of duties, and the creation of broad guidelines and limits that must be followed when making investments. Much like well-run corporations, well-run hedge funds will create a succession plan for its top executives.

2. INEXPERIENCED OR UNTESTED STAFF: Another major question concerns hiring key staff members. Any solution to staffing challenges at hedge funds must include ongoing training that increases employees' current value and helps them improve their overall skill sets. Most major financial services firms have extensive training programs, whereas many young hedge firms have little or no formal training to introduce employees to organizational policies and procedures.

3. UNCLEAR OVERALL BUSINESS VIABILITY: Hundreds of hedge funds close every year all around the world. In 2006, more shuttered their operations than opened. Many successful Wall Street traders and investment bankers open a hedge fund, failing to understand that they are, essentially, opening a small business. Founders of new hedge funds might possess a talent for investing but could find that they're not that adept at the operational aspects of running the fund, such as transaction processing, accounting, building an IT infrastructure, fulfilling regulatory requirements, and managing employees. One clear advantage for those investing in a hedge fund with excellent back-office operations is the scale that can achieve lower trading fees while still offering a full menu of investing strategies.

4. CRUCIAL SERVICE PROVIDERS WITHOUT A STRONG TRACK RECORD SERVING HEDGE FUNDS WITH A SIMILAR INVESTMENT STRATEGY: Relative to most other investment vehicles, hedge funds can invest in a broad swath of instruments across a wide variety of investment strategies. That means they need to establish relationships with a wide variety of crucial service providers. Therefore, Hedge funds must be careful in selecting service providers with deep experience in the business because in a potential hedge fund blow-up, unresponsive counterparties can exacerbate liquidity difficulties to the point where losses wind up being greater than they should be. Hedge funds with a good working relationship with their partners will have a much easier time dealing with situations such as liquidity or margin crises.

5. A CULTURE WITH HAPHAZARD RISK-MANAGEMENT AND INTERNAL-CONTROL STRUCTURES: Institutional investors expect hedge funds to embrace risk management in much the same way a blue-chip financial institution does, with policies governing risk, an infrastructure of risk monitoring and measurement, articulated risk-measurement methodologies, and an enterprise-wide approach that brings risks out of individual business unit silos and to the attention of management. The general internal control environment is one of the best barometers of how seriously a hedge fund takes operational risk. Funds on the leading edge of operational excellence can point to specific controls that track how trades are executed, how financial information is communicated, how orders and reconciliations are processed, and how a system of checks and balances exists among key personnel.

6. NO WRITTEN VALUATION PROCEDURES: According to Capco, 58% of funds face operational risks related to calculating net asset value. The best sign of a consistent, methodical approach to valuation is a written policy and procedures manual devoted to pricing. It's also important to look for a set of valuation checks and balances, which might include a valuation committee to double-check management's valuation calculations as well as a third-party administrator to provide another opinion on both the value of the fund's investments and its consistency of documentation.

7. LIQUIDITY AND LEVERAGE INAPPROPRIATE FOR THE FUND'S INVESTMENT STRUCTURE AND STYLE: Hedge funds are exposed to liquidity risks (runs on the bank) in two ways: fund liquidity and instrument liquidity. Fund liquidity risk occurs when hedge funds use leverage to take positions that are far larger financial commitments than the cash in the fund at any one time. Instrument liquidity pertains to a company holding an inordinately large position in one kind of instrument. Both of these conditions can be compounded by investor liquidity that does not match the fund's investment style and structure. Hedge funds must establish the appropriate gates—limitations on when investors are allowed to exit the fund. Gates ensure that if a big position turns out to be wrong, only a set number of investors can redeem their investments at the same time, preserving the fund's long-term health.

8. GOVERNANCE PRACTICES THAT ARE NOT BEST-IN-CLASS: The key to managing governance issues is to go beyond what's minimally required. In USA in June 2006, the Court of Appeals for the District of Columbia Circuit invalidated an SEC requirement that hedge funds register with the agency as investment advisers and submit to nominal audits. Even without a mandate from the SEC backing them, institutional investors will most likely demand from hedge funds far more detail about investment strategies and guidelines in the offering documents. They'll also likely support tighter terms and conditions around implementation.

9. AN OUTDATED OR INCOMPLETE TECHNOLOGY INFRASTRUCTURE: One of the most important aspects of infrastructure is the adequacy of a fund's IT infrastructure. That fund's systems have to be as integrated as possible to allow timely and accurate information to flow straight through from the back-office to the administrator to the prime broker. A big trading position can head south at any time in this era of global, 24-hour trading, so having the right information at the right time is critical for hedge fund managers.

10. A NON-EXISTENT OR NON-COMPREHENSIVE BUSINESS-CONTINUITY PLAN: For most companies, business continuity means staying operational in the event of a blackout or catastrophic event like a hurricane or flood. That goes for hedge funds, too, because they can't afford to have their IT systems down or electronic trading ability hampered for even a few minutes because it could mean millions of dollars in losses. Given the opportunistic nature of hedge funds, a robust business continuity plan can put them in position to take advantage of any price dislocations that might be happening in the market while others are affected by an unforeseen event.