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Hedge Funds Faces Higher Compliance Standards

Though much of the financial industry has accepted and instituted stronger compliance and oversight measures following the financial crisis, a recent report from Risk.Net leaves many wondering if the hedge fund industry is on the same page. According to a Corgentum Consulting survey of Operational Due Diligence (ODD) analysts, a large majority of risk professionals indicate that compliance and regulatory issues are the leading risks facing hedge funds today. This was followed by accounting and financial statement reviews, legal issues and business continuity risks.

Changes in financial regulation in the United States and around the world have brought increasing regulatory pressure and oversight to an industry that largely operated under the radar in the past. As a result, many firms have little experience in dealing with the complex rules and requirements of the new oversight practices. And the pressure keeps growing. Approximately 1,500 hedge fund managers were forced to register with the Securities and Exchange Commission in 2012 due to provisions under the Dodd-Frank Act, and along with this registration came increased regulatory burdens. These burdens are also not static and therefore require ongoing monitoring and analysis to ensure that firms stay up-to-date with the compliance practices necessary to avoid significant regulatory penalties.

Adding to the complexity, regulation is not uniform worldwide. In fact, the landscape is dramatically shifting in nearly every geographic environment. This creates a very dynamic environment in which hedge funds must constantly evaluate practices to ensure full compliance with complex and changing rules. The implementation of the European Union’s alternative investment fund managers (AIFM) directive is one such change that will bring significant risk to hedge funds operating in the region. Along with these changes, similar regulatory developments are occurring in some Asian markets. This requirement for cross-jurisdictional compliance in such a dynamic environment adds a significant challenge for traditionally small hedge fund management teams.

Most Hedge Funds Poorly Positioned Today to Deal with Regulatory and Compliance Risks

Due to the organizational realities of most hedge funds, regulatory and compliance management are generally not seen as strengths for most organizations. The small team nature of most firms has generally meant in the past that accountability for compliance has been spread out through the organization, with most individuals responsible for ensuring their segments complied with relevant rules and regulations. In the modern compliance environment, however, this is simply insufficient. Investors are pressuring funds to adopt comprehensive compliance management frameworks, with firms reluctant to change being left behind by proactive managers.

Increased Compliance Represents Opportunity for Job Seekers in the Hedge Fund Industry

As late adopters of integrated compliance frameworks, hedge funds will be actively seeking compliance and risk management professionals in order to get their firms  up-to-speed. This issue is of extreme importance, with investors anxious that funds in non-compliance could put themselves in regulatory danger. As a result, financial professionals with experience in compliance and regulatory matters will find themselves in demand over the coming years as hedge funds begin to shift in line with the broader financial industry.

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Hedge Funds Increase Risk Management Capabilities

Since the financial crisis that began in 2007, increased volatility has become the new normal when it comes to managing portfolios. Somewhat surprisingly, the leaders in taking risk have not always put a priority on risk management, placing much of the responsibility with brokers. However, that position seems to be changing, according to a recent Forbes article. Instead of relying on Excel models, hedge funds are demanding new tools that speed up decision-making support within their organizations.

The need for such tools is being driven partially by increased volatility in asset prices. While in the past it may have been acceptable for an analyst to take several hours to turn around findings on an asset’s price trend, today intraday volatility means decisions need to be made without long delays. In order to accomplish this, new expertise and technology is being sought by leading hedge funds.

Complex Securities Demand More Elaborate Risk Analysis

Another area where many hedge fund risk models break down is dealing with non-traditional equity securities. Even for equity focused funds, the increased use of swaps and futures contracts to gain exposure to equity demand increased modeling capability and specific expertise. Correlations need to be constantly monitored on an intraday basis.

Outside of equity funds, those focused on debt securities have even more critical risk management needs. Long-short bond positions and structured finance transactions all require complex modeling that stresses many firms’ existing risk management tools.

Clients Want to Understand Funds’ Risk Practices

Increasingly, institutional investors such as pension funds and insurance companies are becoming leading investment inflow sources for hedge funds. As these typically risk-adverse investors enter the hedge fund industry, more attention is being paid to risk management practices during sales pitches. Not only do clients want upfront knowledge of how risk management is being handled within the hedge fund, but they also want ongoing reporting on various risk exposures. This new reporting obligation certainly hasn’t fit within the risk management frameworks of most funds, again, demanding new skill sets.

What Does this Mean for Job Seekers in the Hedge Fund Industry?

The increased attention that is being paid to risk management within the hedge fund industry will certainly be of interest to risk management professions looking for new opportunities. Such skill sets are somewhat unique, and leaders in the risk management field are generally in high demand across a number of industries. Since the hedge fund industry generally offers higher compensation potential than corporate positions, such opportunities will generally be quite attractive to potential applicants.

The other aspect of risk management that will be in high demand is those charged with implementing and maintaining risk technology. Development of custom software applications and complex financial models are inherent with expanded risk management operations. Individuals experienced with risk management software tools are also likely to be in high demand within the hedge fund industry.

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The Value of Hedge Fund Regulations Questioned

November 19, 2012

After the 2008 stock market collapse, hedge funds faced increased oversight and regulation by financial authorities around the world. This not unexpected, as hedge funds can be amongst the riskiest investment classes in the market, though this is certainly not always true. Nonetheless, the industry as a whole was painted by the same brush, causing […]

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Hedge Funds see a Return of the Institutional Investor

November 5, 2012

Hedge funds have seen a significant change in their investor base in the last year as wealthy individual investors exit the asset class, according to a recent Reuters article, no longer seeing the same return potential in the lower risk strategies being executed by hedge funds today. The industry is beginning a transition back to its roots […]

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Hedge Fund Returns Declining, Risk Taking Up

October 15, 2012

The first three quarters of 2012 have been rather weak for the hedge fund industry, posting returns of 3.04 percent, when compared to the relative strength of the S&P 500 index, which returned 13.97 percent over the same period. Mary Ann Bartels, an analyst with Bank of America Merrill Lynch, told the Financial Post that […]

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