Alternative Data – The Next Due Diligence Challenge

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^[1], 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?

• When prepared, an alt data policy should be adequately detailed and applicable to the extent and types of data which the manager currently (or expects) to use;
• Who owns the policy? Alternative Data should be subject to clear oversight from compliance and risk management functions within the firm.

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.

MNPI

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:

• The source of the information (e.g. a dump of sales data provided by a corporate insider in breach of a confidentiality agreement is clearly different from the purchase of generic satellite images).
• The time sensitivity of information.
• Whether information is individually responsible for generation of an investment idea, or whether it is one contributor to a broader mosaic.

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:

• Privacy issues. As is well known, the EU has serious extra-territorial reach in respect of GDPR and the online privacy rights of EU Citizens. Also, consumer data is highly protected in the EU: as such, the sale of some data sets have been reported as banned by experts.
• Investors should be wary of hedge funds using credit card and email receipt data where the risk, at least according to Integrity Research Associates^[2] is considered to be higher - especially in respect of privacy and insider trading concerns.
• Legal review of the data provider agreement appears of paramount importance, especially given the potential for inadvertent confidentiality breaches downstream. Hedge funds purchasing alt data will need robust contractual and legal protection.

What next?

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.

^[1] https://www.ey.com/Publication/vwLUAssets/ey-key-findings-from-2017-survey/$File/ey-key-findings-from-2017-survey.pdf

^[2] https://www.integrity-research.com/wp-content/uploads/2018/01/Mitigating-Legal-Risks-Alternative-Data-January-2018-2.pdf