The Cayman Islands Financial Services Association says locally domiciled hedge fund administrators and their hedge fund clients are increasingly alert to operational risk management issues.
“Risk is an ever- present component of any investment strategy and is certainly present within the hedge fund industry,” explains the Association. “Traditionally focused more on controlling investment-related risks, the hedge fund industry if compared to, say, the mutual fund industry has placed a somewhat lower emphasis on the operational risks associated with the ongoing administration of funds.”
With a longer operating history, greater regulatory oversight, and relatively simplified and standardized investment programs, mutual fund complexes have had in place fairly robust operational controls for years. Hedge funds, on the other hand, have a shorter operating history and more varied and complex investment programs. The main emphasis has understandably been generating performance efficiencies with operational risk perhaps a secondary consideration.
There is greater evidence that the Cayman Islands’ domiciled fund administrators are viewing operational risk management as a key business distinguisher and therefore high on their strategic goals.
There are a few important drivers for this trend, says the Association. First, closer scrutiny has been directed towards the fund administrators by portfolio managers and institutional investors. They are demanding greater transparency around the overall design and effectiveness of the internal control environment of fund administrators.
Secondly, regulatory pressure, most notably for US registered funds. The new SEC commissioner, Christopher Cox, has indicated his desire to pursue the registration of hedge funds which commenced February 1, 2006, in line with plans set out by his predecessor.
The third and finally driver, is the fact that the industry’s staggering expansion has caused hedge funds to hire additional staff, quite often more than they can thoroughly vet or train. Consequently, they are unusually vulnerable to reputation risk fuelled by poor hiring decisions.
A natural progression for fund managers as a result of these drivers has been the improvement in risk management practices and greater focus on improving internal control environments.
Notably, these improvements are being seen as an ever-increasing opportunity to differentiate themselves for the purposes of competitive advantage. This pressure is subsequently being levied against fund administrators, who are often third-parties, and must demonstrate they are compliant with the highest standards of internal control.
In most cases, potential investors have limited direct access to administrators. Therefore, in order to demonstrate their complicity, many administrators have engaged independent auditors to undertake a Statement of Auditing Standard 70 (SAS 70), with the final deliverable being a SAS 70 report that can then be used for marketing purposes.
There are literately hundreds of administrators operating in many different jurisdictions throughout the world, however, administrators and the services they provide are not always the same.
Investors and investment managers are looking for a common standard to compare administrators. In a sense, a SAS 70 report can be viewed as a common ‘certification’. Around 25 percent of administrators domiciled in the Cayman Islands have sought a SAS 70 report to date. It is easy to envisage a day when investment managers and investors will require administrators to have a SAS 70 report performed on an annual basis.
It is worth noting, that aside from providing assurance to third-parties on the adequacy of the internal control environment, administrators have found a SAS 70 report beneficial as it also highlights control deficiencies and areas that can be improved upon.
With the advent of many recent well publicised internal control deficiencies within other areas of the financial services industry, risk management and the independent auditor’s review of internal control environments looks like an emerging trend that will soon become standard business practice for fund managers and fund administrators alike.
As such, a SAS70 review should be seen not only as a marketing tool that can be used for the purposes of competitive advantage, but also an important component of a fund administrators overall risk management program, due to the operational gains that can be realised within the internal control environment.