Morningstar Operational Risk Flags: Due Diligence Goes Online

By: Steve Deutsch, AllAboutAlpha.com Editorial Board

Last month, Goldman Sachs was ordered to pay $21 million to the unsecured creditors of Bayou Group by an arbitration panel of the Financial Industry Regulatory Authority.  Part of the reason Goldman is paying a fine is that it failed to contact Bayou’s auditors to request additional information on the fund and its holdings.  While the Bayou case pre-dates the Madoff fiasco, this is an opportune time to re-examine hedge fund operational risk.

In January, Morningstar introduced operational risk flags and transparency scores into its proprietary hedge fund database and then into “Morningstar Alternative Investment Center Professional”, an online application that accesses the Morningstar hedge fund database.  I work closely with those who originated and administer the operational risk flags methodology and, although I’m a little biased, I find it to be a useful tool – particularly given the inconsistent standards used in today’s hedge fund industry.

The intriguing aspect of a database of operational risk flags is that the process of due diligence can conceivably be expedited and performed at a lower cost than the existing bespoke methods.  The idea is not that outlandish. Bernie Madoff himself admitted he thought the SEC would ask the very obvious questions that Harry Markopolos identified – such as the unrealistic volume of options Madoff alleged to have traded.  At the very least, automated operational risk flags should be of considerable assistance to investors (who might choose to commission investigative firms for further digging) or to the investigative firms themselves, including Corporate Resolutions, Swiss Analytics, Laven Partners, or Castle Hall Alternatives.

For those interested, Morningstar has published a 12 page methodology document called the  “Morningstar Hedge Fund Operational Risk Flags” (ORF).

According toMorningstar research:

“The light regulation and global availability of hedge funds create unique operational risk issues that are not found with regulated fund investments. Failure to monitor the operations of hedge funds and perform adequate due diligence are contributing factors that allow hedge fund managers and affiliates to perpetrate investment frauds.

Basically, the Morningstar Operational Risk Flags evaluate the following three components:

  • Outside service providers, administrator and auditor, are reviewed for suitability.
  • Voluntary registration efforts.
  • Returns are evaluated for unusual patterns.

The report continues:

“Many hedge funds operate as small businesses with few support personnel. Although some hedge fund management companies have sufficient staff and operations to perform these duties effectively, independence of the fund administrator provides an additional investor protection.

“The auditor’s responsibilities will generally require review of the administrator’s operations and calculations. Therefore, we believe the audit function should be separate from that of the administrator.

“Both administrators and auditors need to have the requisite expertise to evaluate hedge funds. This expertise can be tested in part by seeing if the service provider has an extensive customer list.

Voluntary Registration: Hedge funds as a global investment vehicle have the ability to house operations in a variety of jurisdictions with various regulatory requirements. Choosing to operate in an emerging market and avoiding the minimal regulation that accompanies registering a fund suggest that further due diligence is appropriate.

Return Patterns: Many hedge funds hold illiquid or difficult-to-price securities. The lack of readily available market prices may give hedge fund managers “flexibility” in how they value such positions when calculating returns that they report to hedge fund databases. Sometimes, this pricing flexibility manifests itself in monthly total returns that demonstrate serial correlation – that is, one month’s returns are statistically correlated with the next month’s. Such a signal does not directly indicate that a hedge fund has exhibited pricing flexibility, but it serves as an indication of the possibility. Funds with serial correlation that is higher than its peers are likelier than other funds to own assets that have unreliable prices.

Morningstar uses a standard statistical technique to estimate the level of serial correlation. Hedge funds with serial correlation higher than 90% of funds in a Morningstar Hedge Fund Category are deemed to have higher risk of understated risk or inaccurate pricing.

Though focused on key objective indicators like serial correlation of monthly returns, the Morningstar Operational Risk Flags are not infallable. If a hedge fund manager does not take a few minutes to upload its auditor, administrator, or registration information to Morningstar, the fields then are blank and we raise the flags.  Morningstar is essentially trying to encourage hedge funds to provide this essential information. After all, references are everything in the hedge fund industry, as AllAboutAlpha.com “What Nascar Can Teach Us About Return Persistence. In the end, it’s difficult for a database user to quickly review all flagged hedge funds and see if they have been flagged for questionable information or for simply not providing information.

There is also a “social media” component to the database. Search results are based on the number of times customers of Morningstar’s “Alternative Investment Center Professional”, add a database item into their searches of the database. In effect, customers/investors constantly “vote” on what hedge fund information they deem more or less important by the number of times they include the terms in their searches or screens.

In any event, depending on how much data a hedge fund volunteers to Morningstar, it will receive a raw score between 0-200. Morningstar then ranks the funds and assigns a Transparency Score, ranging between one and five for each hedge fund in the Morningstar database (based on a normal distribution).

Test Driving the Morningstar Operational Risk Flags

To try the Operational Risk Flags, I chose to ignore any hedge fund firm that left the auditor, or administrator, or registration fields blank. 4,788 single strategies were in the original list I pulled. I removed 1,615 strategies because the hedge funds had left the “administrator” field blank. Of the remaining 3,173 single strategies I then removed 544 because the “auditor” field was blank, leaving a group of 2,629 single strategies.

I decided to focus on the “bottom of the barrel,” or the outliers. I screened all the single strategy hedge funds for vehicles that had failed all four flags.  Then, I also screened by the funds that got the lowest transparency score of one. I found 24 single hedge fund strategies that hit all four flags and have the lowest level of transparency.

To supplement – or at least to validate – the Morningstar measures, I hunted around the Internet to find out more about these funds. One fund – let’s call it ABC LLC to protect the name of this potentially innocent, yet decidedly un-transparent manager – made the list of 24 on threee of its four funds (!)  The firm lists “at least $2 million in AUM” and provides a corporate address.

Entering the corporate address into Google Earth turns up an image of what appears to be a strip mall. Sure, it could be high-end strip mall. But suffice to say, strip mall-based hedge funds or service providers have taken a bit of a drubbing after the Madoff affair.

I also located a bio for the founder of ABC LLC on a leading hedge fund industry website. Although he lists himself as a “hedge fund professional,” a bit more Googling revealed that he is perhaps better known as a sports agent. ABC LLC’s accountant, apparently has no website and is apparently not registered with the Public Company Accounting Oversight Board (the “PCAOB”), which has even led to some dismissals from previous business assignments.

The other 23 least transparent fund might simply be super-secretive, or just plain lazy when it comes to submitting their information to our database.  But the results of my little test drive suggest that a lack of information may indeed hint at problems or concerns that need to be addressed by a diligent investor.

Conclusion

The Morningstar Operational Risk Factors and the Morningstar transparency score are not a complete solution. They are just steps in a comprehensive due diligence process that is now more critical than ever for hedge fund investors. However, the Morningstar screen may ease and quicken the task of sorting the good from the bad.

My colleagues are currently working to refine the risk flags and transparency score. Specifically, they are examining whether the risk flag methodology is as helpful when only a few red flags are hoisted. After all, the absence of any due diligence information is quite conspicuous.  And a terrible transparency score may portend a terrible fund. But what about a mediocre score? Does that necessarily indicate a mediocre fund?

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2 Comments

  1. Gabriel Kurland
    July 8, 2010 at 5:02 am

    Operational Due Diligence specialist beware MorningStar will put you out of business.
    The graal that every analyst was looking for in selecting Hedge Funds has been found by MorningStar.
    Regulators stop elaborating new prudential rules, you only need to look at 5 factors and you will know if a fund is risky or not.

    I agree with the argument that analysts are sometimes overcomplicating the operational due diligence process and that short cuts can be found but it seems to me that the MorningStar approch is really oversimplistic. Investors should only use this score as an additional sreening tool but should be very carefull not to base any investment decision on it.

    I regret Hedge Fund Appraisal was not mentionned in your list of Operational Due Diligence service providers.


  2. eddie wilson
    July 9, 2010 at 9:13 am

    When Madoff blew-up, Goldman Sachs went on the record saying their own due diligence had alerted them to the fact that they knew there was something fraudulent going on with Madoff. If this is indeed the case, there is a legal obligation to inform the SEC. Otherwise you are breaking the law. It is a mystery why this has not been pursued by the authorities.


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