As with many financial innovations, hedge funds have become early adopters in the use of alternative data. The advent of new data sources for alpha-hungry managers, however, poses a range of challenges for investors. In this blog, Alex Wise, head of Castle Hall in Australia, explores some of these DD challenges - and some of the potential compliance obligations that might arise.
As a starting point, it is worth recapping some of the sources of alternative data available to investment managers. The generic term “alt data” includes transaction data, data sourced from social media, weather data, and visual or other types of satellite analytics. Data is typically voluminous and may be unstructured, requiring significant processing power and skill to create algorithms to meaningfully mine the information purchased. Indeed, “tech enabled” is a common term – extensive human processing may be needed to scrub raw data before it can become useful for machine algorithms or artificial intelligence techniques.
An example of the use of alternative data would be satellite images compared over time. Automated comparison of images could give a fund manager actionable insights on whether mining operations are expanding or contracting; whether a construction project is progressing on or behind schedule; or, in the famous example, whether there are fewer parked at Wal-Mart as the retailer competes against Amazon.
In terms of footprint, many hedge funds anticipate using alternative data. In fact, according to Ernst and Young’s 2017 Global Hedge Fund Survey, 46% of hedge funds reported in 2017 that they currently use non-traditional data, with a further 32% expecting to use it.
For investors, alternative data creates new due diligence questions. In our experience, the industry seems to be at an early stage when thinking of the impact of alt data on controls and procedures, especially in the area of compliance. While some managers have developed policies around alt data, there is considerable variation in terms of scope and content. Other managers have done little (or simply nothing) to update compliance and operational policies, even if a firm is beginning to consider using large data sets within their investment process.
Looking forward, we have highlighted a number of areas where investors will, over time, look to see managers who do use alt data improve their controls.
Alternative Data Policy
Operational Due Diligence should begin with the expectation that each investment manager has prepared written policies and procedures with respect to each material business function of their organization. Then, in the spirit of “trust but verify”, those procedures (and related committee minutes, for example) should be available for inspection: as such, investors can assess the adequacy of policies and confirm that procedures operate as described.
To date, we have seen relatively few fund managers create a specific “alt data policy”. However, this is reasonable expectation: if alt data is important to a manager’s operations, have they documented their process?
Vendor Due Diligence
Once a potential data source is identified, the fund manager will look to purchase data either directly from a company or through a data vendor or broker. We have not yet seen a consistent trend to complete effective due diligence on the data supplier: however, this would seem to be an advisable goal.
The Compliance Officer is typically best placed to undertake due diligence on the data vendor, ensuring that due diligence is thorough and segregated from the front office investment team. When reviewing a proposed data vendor, questions should include, for example, whether there has been recorded litigation or regulatory sanctions against the data supplier. Does a public records and media search give rise to other concerns impacting the integrity of the vendor?
Further, similar to fund manager ODD, the compliance team’s point in time review is effective….only at the point it was completed. Hedge funds would, therefore, be expected to engage in ongoing monitoring of each alternative data provider, particularly to identify regulatory and compliance issues together with any adverse media.
Evidently, from a compliance perspective, a hedge fund should consider whether data is material non-public information - and therefore inside information - for the purposes of regulatory compliance.
In our view, the question of when use of alt data can result in “crossing the wall” will be a key issue over the next 5 years. As of today, there is little - to nothing - in terms of case law and settled guidance. We expect that a combination of experience, regulation and litigation will likely all be needed to create clearer rules and understanding over time.
In the absence of an established legal and regulatory framework, investors should clearly exercise caution. Overall, does a manager’s use of data, the types of data they use, their rationale for using the data and the controls they have put in place all appear reasonable?
Some immediate factors to consider would be:
As an obvious point, the more extensively a fund manager uses alt data, the more extensively we would expect the CCO to have already focused on alt data issues. A “heavy” user of alt data who cannot provide a plausible commentary around how they consider MNPI would be a clear red flag.
Other Legal Issues
Other areas of legal consideration could include:
We expect alt data to be an increasing focus of investor discussion, and due diligence, over the next 1-3 years. In this emerging space, the hedge fund and wider investment community would be well advised to emerge with enhanced governance and internal industry leadership.
In the meantime, we encourage hedge funds to take ownership from a governance perspective and for investors to ask more questions of their hedge fund managers and other funds that use alt data. As with any specific line of DD questioning, the goal should be to learn more and gain a deeper understanding of the specific risks at each fund – the end game is always to use due diligence to drive better decision making.
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