The investment community was fixated on hedge fund SEC registration for months leading up to the February 2005 deadline, especially managers who were challenged to file their Form ADVs. Successfully completing the necessary planning and paperwork required a great deal of support from nearly every division of individual firms. And now that the dust has settled from the scramble to register, we may think the industry will take some time to catch its breath before improving its core compliance capabilities, and questions abound as to how much SEC scrutiny hedge funds actually will receive.
But neither the recently passed registration deadline nor the potential lack of SEC rule enforcement are good reasons for slowing compliance initiatives. Persistent compliance efforts may be one of the most critical investments in the success of today's hedge funds. Demonstrating that they are behaving ethically and in investors' best interests marks their competitive edge in the marketplace.
Although filing was a significant hurdle for many hedge funds, the real work is now beginning. Demonstrating ongoing compliance includes rigorous record keeping as a registered investment advisor. In addition, with virtually all communication, correspondence and documentation now in electronic form, technology plays a critical role in compliance. Now more than ever, a hedge fund must exercise ongoing vigilance with its approach to managing IT operations.
Given their growing appetite for increasingly complex instruments and trading strategies, implementing a robust technology infrastructure will be critical in satisfying both investors and regulators alike. In light of the SEC's recent risk-based approach to assessing on whom to focus its watchful eye and who to pass over, demonstrating that solid systems are in place will help achieve a "culture of compliance" within hedge funds.
Today's 'Culture of Compliance'
At the heart of a hedge fund's compliance program may be a single, prevailing principle: Do what is right for the investor above and beyond what you may do for yourself. To live up to this principle, firms must create a culture of compliance, which means more than having the right attitude or mind-set. The SEC assesses the culture of compliance at every firm it examines, using the term to characterize the degree to which a firm puts itself at risk. With limited resources, attention from the SEC -- or a lack of scrutiny -- will depend in part on how successful a firm is in demonstrating its culture of compliance to regulators.
Firms that have focused exclusively on implementing strategies and generating returns may find they have not invested enough in operational infrastructure. In addition to established written policies, procedures and practices, regulators will evaluate hedge funds' ability to keep accurate records and deliver them upon request. Many hedge fund managers came from sell-side firms with inherently strong infrastructures, and emphasis on creating equally robust operating environments in new hedge funds may at first have been seen as a luxury.
Technology's impact on today's discussion of compliance -- as virtually all communication, correspondence and documentation has transitioned to electronic -- is proving to dissolve that initial perception. Yesterday's paper trail has been replaced by the "smoking e-mail," and a host of regulations and amendments have been introduced across the investment management landscape in recent years to update requirements governing records retention and monitoring of correspondence for the electronic age.
In the realm of hedge funds, particularly small to mid-size firms, much work needs to be done to establish the culture of compliance through the introduction of technology. Since hedge funds will be required to undergo periodic SEC reviews and be subject to the risk assessments that determine the frequency and intensity of these examinations, technology infrastructure is far from a luxury -- it is now imperative. The necessary technology is the "core compliance infrastructure" that needs to be in place.