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so the paper is the determinance of
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hedge fund internal controls and fees in
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particular what we're examining in this
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voluntary setting unlike mutual funds
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where everything's predetermined why do
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some hedge funds choose particular
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internal controls versus others who
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don't and what we find is there are
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several economic determinants for why in
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this voluntary setting that would happen
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so some examples those that are short
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sellers for example are less likely to
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use internal controls where there's
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oversight you think about why would that
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be well one explanation is short
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squeezing in that if you know the
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positions of a hedge fund who is in a
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short position you could actually take
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advantage of that so you think for these
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particular hedge funds they want to go
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out of their way to ensure there's less
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oversight for these particular issues
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other examples relate to the use of
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better qualified Auditors more reputable
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administrators and also the types of uh
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pricing mechanisms that they use to
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Value the assets we observe that for
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offshore funds the offshore funds are
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actually more likely to have better
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internal controls than what the onshore
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US funds are and one explanation for
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that is that the cost or expense for
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investors to actually uh recoup monies
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should something bad happen is probably
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harder to do in an offshore setting so
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these funds in turn show that they have
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better internal controls so that uh it's
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less likely for this to occur down the
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track another very important result
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relates to younger funds generally
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having better internal controls than
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older funds and this is slightly
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counterintuitive but the main reason is
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if you think that you are a new fund
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it's harder to reveal that you're a high
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quality type and so what you do is you
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say I'm a high quality type I'm going to
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put a lot more oversight in my actions
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therefore you can trust me when you
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invest your money in in our particular
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hedge fund older EST established funds
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or very established that they've proven
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and have a track record so they don't
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have to necessarily go through these
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particular mechanisms so that shows that
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the in a voluntary setting where uh you
00:02:13
don't have any requirements investors
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get to choose whether they invest in
00:02:17
funds hedge funds get to choose what uh
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internal controls they have the people
00:02:21
actually think about the voluntary
00:02:23
choice and that it matters quite a bit
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then it's a case of what could this
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affect and it can affect two things one
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thing is it affect the fees so what we
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find is that those funds that have
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stronger internal controls such as how
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they price assets controlling for
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everything else uh tend to have higher
00:02:41
performance-based fees so often we think
00:02:43
about the expression two and 20 the 20
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represents the the bonus or the
00:02:47
compensation they get above sort of the
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uh zero returns for funds that have
00:02:52
better internal controls this magnitude
00:02:54
is greater and for those that have
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weaker returns it's lower so what that
00:02:57
suggests is that investors realize that
00:03:00
given some funds have better or worse
00:03:02
internal controls this actually matters
00:03:04
in terms of how they reward the managers
00:03:06
down the track we also find some limited
00:03:09
evidence in terms of the types of
00:03:10
internal controls that hedge funds
00:03:12
employ and how that affects future fraud
00:03:15
and we think this is very important
00:03:16
moving forward obviously the sample is
00:03:18
very small but we notice that those
00:03:20
funds that have the manager involved in
00:03:22
the calculation and the reporting of the
00:03:24
net asset value which is the primary uh
00:03:26
number that investors use to uh detm
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what the value of their assets are uh is
00:03:32
associated with a greater likelihood of
00:03:33
fraud so if you get the manager involved
00:03:35
this is a less independent less
00:03:37
objective approach than say just getting
00:03:38
a third party to do it the likelihood of
00:03:40
fraud is substantially greater so that's
00:03:42
a very important result
00:03:49
too well that's a very good question
00:03:51
although when you look now at empirical
00:03:53
evidence given that we've had many
00:03:55
frauds over the past few years there are
00:03:57
some common uh factors related to these
00:04:00
and they primarily relate to the use of
00:04:02
a custodian the fact that is the manager
00:04:05
involved in this calculation of the NIV
00:04:07
navv statement uh so now that we know a
00:04:10
lot more about why certain frauds occur
00:04:13
uh maybe that will prevent it of course
00:04:15
in this unregulated setting unlike
00:04:17
mutual funds there are a lot of
00:04:18
protections that are regulated in place
00:04:20
which cost the hedge funds and the
00:04:21
investors money to set up uh in settings
00:04:23
like the hedge funds we don't have to do
00:04:25
that uh it's completely up to the
00:04:27
discretion of the investor I think
00:04:29
looking forward
00:04:30
and moving forward I think that
00:04:32
investors are going to think very
00:04:33
carefully in terms of which funds they
00:04:35
invest in based on the strength of the
00:04:37
internal controls and talking to a lot
00:04:39
of institutional investors they already
00:04:41
uh many years ago had decided not to
00:04:43
invest in particular funds because they
00:04:46
thought the internal controls were not
00:04:47
strong enough even given the quality of
00:04:50
the hedge fund manager moving
00:04:57
forward I think first for regulators
00:04:59
we're talking about a period right now
00:05:01
where we want to protect investors to a
00:05:02
greater extent than what we've currently
00:05:04
done now to the extent that the
00:05:07
investors are not aware that certain
00:05:08
internal controls matter our research
00:05:10
actually suggests that investors do
00:05:12
notice and they take this into account
00:05:14
when they determine the types of fees
00:05:15
that they decide to charge in
00:05:17
conjunction with the hedge fund manager
00:05:19
so it's not as if these sophisticated
00:05:21
investors don't know what's going on so
00:05:22
I think they do one also implication of
00:05:25
the research relates to the incidents of
00:05:27
Fraud and things like that and we're
00:05:28
seeing at the moment particular types of
00:05:30
internal controls being forced uh maybe
00:05:33
upon uh hedge funds which will reduce
00:05:35
the likelihood of fraud the results if
00:05:38
we know that certain internal controls
00:05:40
prevent fraud there's no reason why a
00:05:42
sophisticated investor would choose not
00:05:43
to would choose to invest or not to
00:05:45
invest in a particular fund given they
00:05:47
know that certain inter internal
00:05:48
controls matter now whether we want to
00:05:50
spend a lot of government resources to
00:05:52
protect managers uh sorry investors even
00:05:55
given we know this empirical evidence
00:05:57
which suggests that some internal
00:05:58
controls matter well that's that's a
00:06:00
case sort of where in policy you said so
00:06:03
I'll leave that open but finally for
00:06:05
hedge fund managers I think they just
00:06:07
confirms what they know that investors
00:06:09
do take all these things into
00:06:11
consideration and the choice of
00:06:12
implementing internal controls is costly
00:06:14
both from an explicit cost in terms of
00:06:16
your choice of auditor or getting a
00:06:17
third party value to come in and they
00:06:19
have to be traded off against the
00:06:21
benefits such as do you get higher fees
00:06:23
or does this oversight allow certain
00:06:25
investors who may otherwise wouldn't
00:06:27
have invested in The Firm to now invest
00:06:28
in you so I think that as this research
00:06:31
uh and other sort of accompanying
00:06:34
research is coming out I it's not
00:06:35
necessarily clear that by regulating and
00:06:38
to solve the problems but what certainly
00:06:39
is clear is some internal controls do
00:06:42
matter and the choice of internal
00:06:43
controls is something that we can uh
00:06:45
explain through economic
00:06:57
determinant
