CHAPTER 3 The Operational Risk Crisis. As the hedge fund industry has grown explosively, so too has the list of fund failures and burned investors, many of whom did not have advance knowledge of potential warning signs. It seems as if we are constantly faced with news reports about catastrophic losses incurred by some of the industry’s best-known managers | 3 13 The Operational Risk Crisis As the hedge fund industry has grown explosively so too has the list of fund failures and burned investors many of whom did not have advance knowledge of potential warning signs. It seems as if we are constantly faced with news reports about catastrophic losses incurred by some of the industry s best-known managers and even those investors who insist on a comprehensive due diligence process are not immune. To better understand why hedge funds fail and how these failures could be avoided Capco conducted a recent study to assess why failures occur in the hedge fund industry. The findings of the study are compelling. The main area of concern is that operational issues account for 50 percent of hedge fund failures an alarmingly high percentage. With that in mind the key point of interest to hedge fund investors is that they must expand their due diligence and monitoring practices to ensure that they understand the back-office capabilities of the hedge funds with which they are contemplating an investment. This understanding can make a big difference in preventing or avoiding a bad investment decision. As background it should be noted that this study is based on a database of hedge fund failures that dates back 20 years and captures details of losses litigation and root causes. Failed funds are considered those that had been forced to cease investment operations suddenly and where investors faced a significant or total loss of capital. This differs from a Stuart Feffer PhD and Christopher Kundro 43 44 HEDGES ON HEDGE FUNDS more common discretionary fund closure where a manager chooses to unwind a fund over time and in an orderly manner. The findings are based on over 100 failed funds over this period. The primary cause of each fund s failure attributed to at least one of these factors representing three basic categories of risk 1. Investment Risk. These risks are market and related risks associated with the investment style of the fund .
