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Pressures facing alternative investment fund managers

INVESTMENT INDUSTRY INSIGHTS  | 

Alternative investment fund managers are facing never-before-seen pressures to perform with higher compliance standards from regulators and threats of a breach in cybersecurity just add to a challenging operational environment.

"Hedge fund managers complain that it's harder than ever to make money amidst the constant worrisome knowledge that regulation has raised costs exponentially," said Harvey Pitt, the former SEC chairman, at the recent Hedge Fund Association (HFA) Symposium in Stamford, Connecticut. Last year, according to Pitt, the average hedge fund returned 3 percent compared with a gain of 13.7 percent for the S&P 500. "These factors have caused some alternative investment funds to close up shop."

John T. Hague, RSM partner and financial services industry leader agrees, "The industry's fee structures are under close scrutiny. In addition, internal costs have risen due to changing regulations and best practices. These considerations in a year when performance lagged the S&P market have stressed the industry."

With fewer competitors and more fund investors seeking alternative investment vehicles, some would think that those left behind would do better with fund raising, but it's not necessarily the case, according to Pitt.

Last year, California Public Employees' Retirement System (CAlPERS) announced it would eliminate all $4 billion of its hedge fund investments. Within the last 6 months, hedge funds have experienced nearly $35 billion in redemptions. Not a positive sign for the industry at large.

"Funds need to determine if they are being paid for performance, or if they are being paid for a pulse," said Pitt.

Pitt emphasized that the recent overturned conviction of the insider trading case, the Newman Decision, should not be looked upon as a gift to the industry. "The problem with Newman is it may lull some folks into thinking that they can be more aggressive with information they probably shouldn't have received and on the basis of which they certainly shouldn't have traded," he said. "That spells bad news for alternative asset managers. It's hard enough these days to supervise traders and other employees. Imagine how tough it will be when those folks get inside their heads the notion that they've been given carte blanche."

If a traditional bullish market and the threat of an SEC audit aren't enough facing alternative investment fund managers, there is the ever-increasing cost in protecting data in the behemoth task of cybersecurity.

Global IT security spending will increase by almost 8 percent to nearly $77 billion in 2015, according to IT research firm, Gartner, Inc. According to the FBI, in the 12 months from October 2013 to October 2014, 500 million financial records were stolen by hackers and approximately 35 percent of the data thefts were from website breaches, and 22 percent were from cyber espionage.

"Dealing with cybersecurity must be made an important part of the overall culture of an organization," according to Alan Alzfan, RSM partner and hedge fund industry leader. "Top management must stress this area just as they stress other important compliance issues. Everyone must constantly be reminded of how one incident can ruin an organization and how important each person in the organization is to the program. Like any other compliance program, cybersecurity must be constantly reviewed and updated. The importance of updating the program cannot be over emphasized as new threats are constantly being deployed and your company is constantly being attacked, either directly or indirectly."

Pitt explained to the group of hedge fund managers that cybersecurity should be handled in three steps, the first being an assessment of how secure a company's data is. "Do you currently know how vulnerable your data is?" he asked.

He emphasized that knowing and thinking about where vulnerabilities are, were two totally different realities. Just because no one has told you that you are vulnerable, doesn't mean that you aren't. "You have to figure out if you are easy to hack, and if so, fix that," said Pitt. "Don't be an easy target, the harder they have to work, the more likely they will seek other targets."

The second step has to reflect the reality that no matter how hard you try to prevent hacking it's likely to occur anyway. "You want to minimize the effects of any breach in security that does occur. This requires serious planning," said Pitt.

Automated preventative practices built into software are good steps in the right direction, but firms have to let everyone in on the ramifications if something triggers the software, said Pitt, referring to the recent NASDAQ software glitch that shut down trading for hours which caused great disruption and upheaval.

This leads us to the third and final step on how to handle cybersecurity, to be transparent. "Transparency is always your best method of retaining your investor base," said Pitt. "When these problems arise, your investors worry about them, they worry about whether your fund was affected, they worry about what you are doing to protect their interests."

Firms need to have a game plan on how to respond on what they will do and to whom they will speak so they can attempt to control these events as much as possible rather than allowing events to control them.

"The one thing that we all know is that all firewalls can be, and likely will be, breached and probably sooner rather than later," said Pitt. "You all have crucial and sensitive proprietary and client information. For the sake of your own business and your client's peace of mind, you have to protect that information from hackers as best you can."