Operational Due Diligence in Currency Investment

By Jerome Lussan and Robert Mirsky - Laven Partners

Private individuals, family offices and institutional investors of all sizes are often insufficiently resourced to carry out thorough operational due diligence. This became obvious following the financial crisis as many managers held worthless assets without marking them to market or made highly correlated losses to equity markets. Hence a strong trend to delegate this task to independent professionals and reassure clients that the job is both complete and awithout conflict of interest. With currency managers in particular, many investors seeking currency overlay strategies have hired external specialists to ensure potential portfolio managers are truly meeting their allocation requirements.

Taking qualified external advice when considering investing in currency managers will not only help in understanding the operational risks of the relevant manager but importantly, will help in selecting the appropriate product and product structure without relying on a potentially conflicted bank or platform manager.

Certain investors do not wish to invest through a traditional fund structure usually for reasons of liquidity or leverage and prefer to place the currency risk management program in a separately managed mandate. This provides the investor with a certain degree of flexibility regarding choice of service providers, such as the execution brokers and the valuation agent. Importantly, any position can be watched closely and cut if the risk limits are reached. Although this allows for a greater level of transparency, investors still need to be aware of the higher costs of running and supervising multiple managed accounts. Additionally, a simple managed account structure does not validate actual operations or the long term value of the relevant strategy.

Currency managed accounts may also differ from using separate vehicles incorporated into a client mandate or using an institutional platform. Again, investors will have to either understand the structures and the costs of establishing one, or effectively carry out due diligence on any institutional platform to better understand the trading process, counterparty risks and additional costs of using a platform. There are clearly advantages and disadvantages to both, the key is to be clear on the needs of your portfolio and the costs that the portfolio can assume in relation to the risk / return profile of an underlying strategy.

Because currency trading is often done via spot trading, futures and options and therefore on margin, investors in currency overlay strategies tend to favour managed accounts. In this context, currencies are chosen for their low risk profiles and due diligence will assist in determining the reliability and discipline of the relevant managers as well as the operations that support that strategy.

Due Diligence - Initial Assessment

JEROME LUSSAN

"Investors in currency managers should also consider risk factors such as tracking error between various accounts/funds and slippage and trade execution issues such as costs which may have an impact on smaller client portfolios."

The majority of hedge fund currency managers are either proprietary traders or systematic traders. The former typically rely on global economic views and the latter on models designed to trade within a set of defined parameters. The inherent risks between physical trading and a model which simply selects potential strategies through portfolio simulations are very different. The key is to appreciate how alpha is generated and the risks that could impair alpha generation, or cause a major loss. For example, disaster recovery and back up plans are particularly important for high frequency systematic traders whose failure to close their positions promptly, may be costly. Even a short power cut could have an acute affect on the outcome of their work; hence investors should be able to assess the business continuity infrastructure in addition to enquiring as to whether any recovery tests have been performed in the past. This is still relevant for proprietary traders, for example where there are no stop orders with brokers. Again, due diligence would perform a review to see if stop orders are used and are they applied with rigor so that there is limited risk of errors. In other words, due diligence identifies whether the process is in place and its application.

Investors in currency managers should also consider risk factors such as tracking error between various accounts/funds and slippage and trade execution issues such as costs which may have an impact on smaller client portfolios. From a risk management perspective, currency managers should be using stop losses. It is a matter of probability that a manager trading foreign exchange markets will be subject to a market reversal caused by some unforeseen geopolitical event. Therefore to know that there is a system to stop losses widening (as well as to take profits to lock in gains) is extremely important.

Within the analysis of the track record it is also important to assess the impact of leverage as well as the effect of the growth of assets under management. It is not uncommon to see that managers with lower assets use more leverage and often trade with more success as a result. It is simple to check this through AUM analysis, discounting performance for leverage effect or simply focussing on the level of risk in the portfolio using measures such as the information ratio or the 12 month rolling volatility.

Both retail and institutional investors should take a number of steps in order to ensure that proper due diligence is carried out prior to an investment being made. Investors should also remember that to make the most of an on site meeting they should carry out their own research prior to meeting the manager, by gathering as much information as possible. By reviewing the company/partnership formation documents, investment management and advisory agreements, service provider agreements and other key documents (such as pricing policies), an investor can obtain up to seventy percent of due diligence information required in advance of meeting the portfolio manager in person. This means a more efficient use of the time of both the investor and managers' staff.

Visiting the Manager

ROBERT MIRSKY

"Surprisingly, many retail and institutional investors still fail to undertake the most basic level of due diligence, such as checking registration details with regulatory authorities."

Investors should consider an onsite visit to the manager enabling them to meet not only the portfolio managers, but also the individuals working in the front and back office particularly those who oversee functions such as risk management. It is advisable to take a tour around the office and look at the physical infrastructure to evaluate whether the portfolio managers have robust systems in place to both manage and support various currency strategies.

In terms of the review of trading models, it is important to note that many traders rely on models which do not have the ability to stand the test of time as markets evolve. A high degree of expertise to assess those models rather than relying on the person that designed it is a key to robust due diligence.

Moreover, because currency trading leaves significant cash uninvested, investors should check any risk that exists for the cash itself. There are both counterparty and fraud risks in the holding and movement of cash. For example, if a manager states that they use multiple signatures for cash transfer policies, it is important to review evidence such as recently executed transfers in order to verify whether this happens in practice or whether a single signature can wire money out to any third party account.

Recent Examples

Surprisingly, many retail and institutional investors still fail to undertake the most basic level of due diligence, such as checking registration details with regulatory authorities. Most information, such as previous fines for US based managers can for example be found on the National Futures Association ("NFA") and the Commodity Futures Trading Commission ("CFTC") websites. A recent example includes Dennis Todd Hagemann and Yellowstone Partners who were alleged to have fraudulently persuaded individuals to invest in foreign currency futures, managed accounts and pooled investments. One of the claims made against the defendant included that he and other employees were registered with the NFA, where in reality the firm did not even have employees let alone a registration with the NFA. Another essential point is the importance of analysing the underlying products in the portfolio by looking not only at strategy allocation and attribution reports, but also bearing in mind relative risk profiles and performing sample checks of historical prime broker statements and trial balances. For example, the risk profile of a manager trading highly liquid G3 (US Dollar, Euro and Yen) or G20 currencies will differ substantially to one performing more exotic carry trades. A further example includes Lake Shore Asset Management Ltd, a commodity pool operator which was alleged to have falsely stated that it consistently generated positive returns from 1993, including between January 2002 and September 2007 when it actually experienced high trading losses. A simple check of the historical trial balances would have revealed whether such information was correct or not.

Operations

The valuation of instruments is also very important as certain currency markets may face pricing difficulties due to small trading volumes. Consequently, independent third party valuation is essential to achieve a best practice valuation result.

Another key area of operational due diligence for currency investors should be adherence to a best execution policy. Because of high portfolio turnover, investors need to ensure that the transactional costs for managers and indirectly investors are minimal especially as this may vary between brokers.

Following their visit, investors should compare what they have learned with their own research in order to verify whether the information provided by the personnel onsite is reliable. Any additional queries should be followed up by a conference call or a second visit providing the portfolio manager with the opportunity to clarify any outstanding issues.

Service Providers

Investors should also reach out to the fund's service providers, as they have independent insight into the operations of a manager. Specifically, the administrator holds the pricing policy of the fund and a prime broker (although with currency traders these are usually clearing houses) assists in the process of asset verification. It is however highly likely that the legal advisor or auditor will be reluctant to provide any sensitive information. Service providers can be encouraged to release information if given sign-off or an indemnity by the fund manager.

Ultimately, within the due diligence process, the qualitative and quantitative data should be combined. In the quantitative criteria, correlations are paramount in order to determine whether the portfolio manager has traded well outside a predetermined benchmark or set of expected returns. Moreover, a review of the rolling returns and volatility measured on a 12 month rolling basis does help with the evaluation of the portfolio manager's trading patterns in addition to the alpha/beta assessment allowing the investor to determine whether the strategy is sustainable in the long term. Following the initial due diligence and onsite visit, ongoing monitoring is crucial as the fundamentals might change significantly. It is advisable for the investor to track quarterly, if not monthly changes in all key areas such as investment strategies, personnel and assets by either conducting manager calls or suggesting they respond to a template document with standard questions.

Trading

Larger hedge funds and in particular global macro players, are prone to becoming aggressive currency speculators, as highlighted in both the 1996 Asia currency crisis and the 1992 Black Wednesday UK currency crisis. The current big play is the Euro with rumours circulating that major players are preparing to cash in on the depreciation of this currency.

A major advantage currency managers have over other strategies is that they are able to shift their positions quickly reflecting any changes in market conditions. However it must be noted that the time period during which the currency basket is traded is of utmost importance as different time frames would impact volatility and risk management factors. For example, a fund that trades short term, medium term and long term currency baskets must manage the depreciation risk, transactional risk and interest risk concurrently.

Liquidity risks therefore for many foreign exchange products are lower due to the fact that currency markets possess higher levels of liquidity. Nevertheless, investors should analyse redemption terms carefully and look for potential gates in addition to being realistic in terms of how much time it will take them to extricate themselves from the investment.

Transparency

Increased pressure from investors for transparency, as well as a general decline of inflow to the industry, has facilitated the receptiveness of managers to operational due diligence. In particular, portfolio managers are now more likely to divulge details of their operational and risk management structures to prove operational effectiveness and encourage investment.

Additionally, currency management strategies have become more attractive due to their high liquidity and lack of correlation in comparison to traditional bond and equity markets. They are now broadly perceived as a separate asset class.

For the diary

37th Annual European Finance
Association Meeting
www.efa2010.org
25 - 28th August 2010

Funds Forum China
www.fundsforumchina.com/index.html
8th - 9th September 2010

World Alternative Investment Summit Canada
http://www.waisc.com
13th - 15th September 2010

Alpha Hedge
www.ii-alphahedge.com/index.cfm
?sc=20100927_AI_0001
26th - 28th September 2010

Capital IQ Investor Leadership Forum
www.capitaliqilf.com/Events/2010/
New-York-Forum/Event-Overview
5th October 2010

The Cyprus Investment and
Wealth Management Conference
www.imh.com.cy/index.php?id=434
7th October 2010

Asset Allocation Summit Europe
www.terrapinn.com/2010/
aas/Programme_5367.stm
11th - 13th October 2010

UK Pensions & Investments Summit
http://www.ukpensions-summit.com
18th - 20th October 2010

XVIII Finance Forum
www.uch.ceu.es/principal/jornadas/
2010/forofinanzas/index.asp?op=home
18th -19th November 2010

Alternative Investments Europe Summit 2010
www.aie-summit.com
29th Nov - 1st December 2010

Quantitative Methods in
Finance Conference
www.qfrc.uts.edu.au/qmf
15th -18th December 2010

This global changes impacting the level of hedge fund regulation has also indirectly increased independent risk oversight within regulated firms by causing such firms to adopt operational risk procedures.

Eventually it should become standard practice and a prerequisite for portfolio managers to release unambiguous information to investors, such as large positions and exposures in their portfolio or by providing them with documents such as compliance manuals, valuation policies and risk management procedures. Investment businesses will have to evolve continuously in order to maintain their competitive edge over other less transparent firms.

Conclusion

The recent financial crisis has given us a number of lessons to be learned; most importantly to conduct proper assessments and operational due diligence. Extraordinarily, many still expend greater effort and time buying a holiday than calculating the risks ahead of investing their money in hedge funds. This is in part still due to the naive belief that hedge funds operate like mutual funds and that track record is the only key to a strong investment.

After experiencing significant losses, liquidations, freezing of assets and exit restrictions, investors have become far more risk aware and are requiring greater transparency and accountability in the managers that look after their investments. This must be further encouraged and the costs of additional due diligence factored when dealing with any investments.