by Mark Noble

Do investors really know the risks associated with their chosen investments? For many of them, the answer may be no, according to Craig Asche, [executive] director of the Chartered Alternative Investment Analyst Association.

Asche, who heads up the Massachusetts-based association that accredits the CAIA designation, was in Toronto last week to meet with key stakeholders in Canada's alternative investment community. He points out that some money managers have not taken into account the cost of due diligence in running their mandates.

In his view, for every Bernie Madoff - outright fraudster - many more hedge funds are done in by the miscalculation of operational risks. For instance, forced liquidation has been a huge issue for hedge funds.

The short-selling ban and the collapse of Lehman Brothers left many hedge funds holding largely illiquid assets. Of course, to survive a liquidity crunch, many funds have to sell off their higher-quality assets.

"Nobody is happy with what's happened to hedge funds, but I would argue that hedge funds are as much a victim as the investors were. A lot of the things that contributed to the poor results in hedge funds were outside their control," he said. "Look at the short-selling bans and the problems Lehman Brothers created as a prime broker. There were a lot of losses created by those dislocations in the environment."

These types of risks - which are obviously very real - require a re-conceptualization of the risk models used by the industry.

"Certainly on the quantitative side, there has been too much reliance on using historical data to develop the models. Clearly these events we historically look at as being three- to five-point standard deviation events are happening with more frequency. That being the case, risk models need to be adjusted," Asche said. "There has also been a shortfall in institutional management, those managers look at their asset exposure in terms of the assumptions they are making. In normal times, you can assume normal relations will hold."

Asche points out these are abnormal times, and the correlations of assets have increased - mostly all heading down. Things like counterparty and liquidity risk have been major factors in strategy performance.

However, risk modelling and looking at the strategies employed by hedge funds are only one part of the due diligence equation.

The other is the operational risk. This is an area in which specialized knowledge of the hedge fund industry is required, Asche points out.

"There is a very good case to be made of separating due diligence into two components. You look at the strategy: does it fit with what I'm trying to accomplish? Is it appropriate for this structure?" Asche says. "Then you have to look at it from the operational side and really determine everything is appropriate. Does a manager have that independence? Is there enough independent verification of what a manager claims? You must separate those two assumptions so that if either side says no, it's a no to investing with it."

Many advisors don't have either the CAIA or CFA designation. This may eventually call into question the fiduciary competence of advisors recommending alternative investment mandates without the help of a regulated investment counsel.

"If you don't have the ability to do the due diligence, and you don't have the resources to hire somebody independently to do it for you, you shouldn't be invested in it - you just shouldn't," Asche says.

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