Taking Stock: Are Loose Personal Trading Policies at Hedge Funds a Red Flag?

March 28, 2017 / by Kevin Lau-Hansen, Senior Operational Due Diligence Analyst

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In this era of heightened scrutiny into investment practices by regulators and investors, it isn’t surprising that a particular area of focus while conducting operational due diligence is the personal trading policies at hedge funds. For one, charges of insider trading—even those that are yet unproven—can do serious reputational damage to the manager. They are also a headache for the fund’s investors who are not compensated for this operational risk; nor do they benefit from an employee’s personal trades. What is surprising, however, are the lax controls at some hedge funds and their slow pace of embracing compliance policies widely considered best practice in the industry.   

Prevailing standards advocated by compliance officers and consulting firms call for generally restrictive personal trading policies, with exemptions for passive investments, mutual funds, sovereign debt (such as Treasuries) and non-discretionary accounts. Trading individual securities are typically prohibited or heavily monitored with sales of only legacy positions permitted after pre-approval. At the least, trading in individual securities or ETFs should require a minimum holding period and clearance from the fund’s compliance team while entering and exiting positions.

Most hedge fund compliance programs pay special attention to market manipulation in efforts to not set off regulatory alarms. A common tack for managers involves reporting on portfolio names at the center of major news or market events, and cross-checking the fund’s trading dates versus that information; overlaps are flagged for follow up at the firm. This process may raise a disproportionate number of false red flags but it prepares funds to withstand scrutiny from regulators.

Personal trading policies for individuals usually do not attract this level of attention from fund managers. This could render the firm vulnerable if an employee’s personal trades catch the eye of a regulator. At the same time, the fund doesn’t profit from these trades, skewing the risk-return ratio in favor of the employee. The insider-trading charges leveled by the Securities and Exchange Commission against hedge fund Omega Advisors and its prolific Chairman and CEO Leon Cooperman are a testament to what can go wrong in the absence of strict safeguards against personal trading. While Mr. Cooperman has refuted these charges and the case is currently open, this can adversely impact the firm’s standing and investor sentiment.  Strict personal trading policies are designed to reduce the chances of this happening and compliance officers are tasked with recording any exceptions that are granted so a firm is prepared for its next regulatory check.

Some may question why hedge fund managers are prohibited from personal gains from trades given they are paid for their superior security selection. The short answer: they’re not. The incentive fees they receive are designed to reward managers for their superior security selection to the extent it benefits outside investors. Additionally, hedge fund managers typically invest their personal capital alongside external investors, thus profiting directly from gains earned by the fund. While portfolio analysts may not always benefit directly from incentive fee income, they usually earn deferred compensation which vests within the fund.

That said, from time to time operational due diligence still uncovers inadequate controls around personal trading by hedge fund employees. With the potential risks invariably outweighing the would-be benefits, this area will continue to be the focus of regulators and investors alike.

Topics: Endowments & Foundations, Private Wealth, Hedge Funds, Operational Due Diligence, Commentary

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