LONDON (HedgeWorld.com)–Institutional investors are putting more money into hedge funds, but need to match that with more scrutiny of risk processes to protect against operational failure and fraud when choosing managers, according to a new study from the Bank of New York in conjunction with Amber Partners, a risk certification firm.

To address this, the bank has published a set of criteria for investors outlining key risks, aside from investment performance, that could damage a portfolio. A key focus of the study, entitled Hedge Fund Operational Risk, is the risk of manager manipulation of portfolio pricing. “There will be managers who have good grades on having these tools, but more who fail in some areas,” said David Aldrich, a London-based managing director of BoNY.

“What we are saying is that there is no need to be afraid of hedge funds,” Mr. Aldrich said. “There are people like BoNY who provide infrastructure and automation [to aid valuations] and people like Amber who certify hedge funds.”

A priority for all hedge funds, according to the study, should be an experienced chief financial or chief operating officer running the day-to-day business. Each firm should also have a chief compliance officer and a compliance charter setting out policies on personal trading, trading errors and soft-dollar commission usage.

The study outlines the need for procedures and internal controls to be in place over each stage of the trading cycle. As well, managers trading in over-the-counter derivatives and firms with heavy volumes need specialised systems and staff.

The study noted that regulators in both the United States and the United Kingdom are focusing on pricing practices and are seeking more independent valuations. It added that hedge funds that use third-party administrators and auditors will show investors that their processes are outside the influence of fund managers.

Mr. Aldrich said the structure of hedge fund businesses is changing rapidly. “It’s no longer as simple as having the brightest group of traders. Now you need to be a much bigger-scale business. It means the break-even point of setting up a hedge fund business is much higher. If you want to get the institutional money or fund of funds you need to set up for it at the beginning.”

BMcIntosh@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.