Hedge Fund Trade Error Policy: Who Bears the Loss and What Allocators Expect to See

A hedge fund trade error policy answers one question before it is asked in anger: when the manager's mistake costs the fund money, who pays. The institutional default is that the manager bears the loss and the fund keeps any gain, and for a US adviser that default rests on the fiduciary duty enforced under Section 206 of the Investment Advisers Act of 1940. The SEC's July 2020 settled order against Franklin Advisers shows what happens when a firm's policy says one thing and its conduct does another. This article sets out what the policy must define, how it is read with the offering document and the investment management agreement, and what the error log, the board and the administrator should see.

"We ask for the trade error policy early because it tells us how a manager behaves when something has gone wrong and nobody outside the firm has noticed yet. The strong version is short. It defines an error before one happens, says plainly that the manager bears the loss unless the fund documents say otherwise, and commits the firm to a log that the board and the administrator can see. What we are wary of is a policy that leaves the definition to the moment, because that is when the incentive to call a mistake a judgement is strongest." David Lloyd, Chief Executive Officer at CV5 Capital

Executive Summary

The trade error policy is among the first documents an operational due diligence team requests and among those most often missing from an emerging manager's estate. Its value lies in a definition, a loss rule, and a record that proves the rule was applied.

• An error is a failure in execution, allocation, authorisation or compliance with a stated restriction; an investment decision that lost money is not an error.
• The default is that the manager bears the loss and the fund keeps the gain, subject to the standard of care and exculpation terms in the fund documents.
• Gains and losses from the same error net to a single figure; netting across unrelated errors or across funds moves value from investors to the manager.
• The error log is the evidence file, and its fields should be fixed by the policy rather than reconstructed after the fact.
• Materiality thresholds decide what reaches the board and the administrator, and the CIMA Rule on Corporate Governance for Regulated Entities makes oversight of internal controls a board duty.

Why the Trade Error Policy Is Requested So Early

Operational due diligence teams ask for the trade error policy alongside the valuation policy and the compliance manual, usually before anything strategy specific. Every manager will make an execution mistake at some point, so the question is whether the firm decided in advance how to recognise, price, resolve and record it. A policy written after the first serious error is written under the pressure of that error.

Editions of the AIMA Illustrative Questionnaire for the Due Diligence of Investment Managers have long asked the manager to describe its policy on trading and system errors and to confirm that trades are reconciled to broker confirmations. The current edition separates trading questions from the operations and risk management module, so error handling is read with the head of operations rather than the portfolio manager. CV5 has set out how to approach the questionnaire in answering the AIMA DDQ; the error question rewards a short, specific answer.

The policy also sits between two other documents an allocator reads. The expense allocation policy decides what the fund can be charged for, and an error loss is the clearest example of a cost the fund should not bear. Trade operations decide how quickly an error is caught, and the hidden cost of poor trade operations is largely the cost of errors found late.

What Counts as an Error and What Does Not

The definition is the load-bearing part of the policy. Too narrow, and genuine mistakes escape the process; too broad, and every losing trade becomes a claim against the manager. The institutional approach defines an error by the process that failed, not by the outcome. A trade executed as intended, within the mandate, that then lost money is an investment decision. A trade that departed from the instruction, the mandate, the authorisation or a restriction is an error, whether or not it lost money.

The Standards Board for Alternative Investments published a memo in March 2024 on trade errors, omissions and breaches which draws the same line. Its narrow definition covers execution failures such as a buy entered instead of a sell or the wrong security traded. Breaches of the investment mandate are a separate category that a firm may bring inside the policy or handle under a breach procedure. The policy must take a position on each category and apply it consistently, and in a systematic strategy the definition must reach code changes as well as order tickets.

Who Bears the Loss: The Default and Its Exceptions

The default is simple: the manager bears the loss on an error and the fund keeps any gain. It is not a statutory rule; it follows from the manager's duty to the fund and from the documents the manager signed. For a US adviser, the SEC's 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers describes the fiduciary duty as a duty of care and a duty of loyalty. The duty of care includes seeking best execution of a client's transactions. The interpretation states that the federal fiduciary duty may not be waived, although it applies in a manner that reflects the agreed scope of the relationship.

The exceptions live in the fund documents, which is why the policy cannot be read alone. The investment management agreement will usually contain a standard of care with an exculpation and indemnity clause. In institutional practice the manager is exculpated for losses other than those caused by its fraud, wilful default or gross negligence, with ordinary negligence a matter of negotiation. A pure execution error is typically negligent rather than grossly negligent, so the manager may have a contractual argument that it is not liable. The policy is where the manager gives that argument up and commits to reimbursement regardless, as a voluntary and disclosed undertaking.

The SEC's settled order against Franklin Advisers, Investment Advisers Act Release No. 5531 of 2 July 2020, shows the consequence of a gap between policy and conduct. The adviser's policy normally required it to reimburse client losses on a security bought or sold in contravention of regulatory investment restrictions. When corrective sales caused realised losses of 2,184,031 US dollars, the adviser initially declined to reimburse.

Its reports to the funds' board omitted the losses, the decision not to reimburse, the associated conflict and its failure to follow its own procedures. The SEC found violations of Section 206(2), Section 206(4) and Rule 206(4)-7. The lesson for a private fund manager is that a policy, once adopted and provided to a governing body, becomes the standard against which conduct is measured.

Netting: Within an Error and Across Errors

A single error often produces both a gain and a loss. An order entered for the wrong quantity, discovered the next morning and corrected, may show a gain on the excess bought and a loss on the unwind. Netting these is uncontroversial, because they are two legs of one mistake. The policy should measure the error from the erroneous trade to the moment the intended position is restored, and treat the net result as the error amount.

Netting across unrelated errors is a different proposition. A manager who offsets the gain from one mistake against the loss from another, over a quarter or a year, is using the fund's gain to pay the manager's liability. The fund would have kept that gain under the default rule. Netting across funds, where one fund's gain covers another's loss, cannot be reconciled with the manager's duty to each fund separately. The SBAI memo lists error accounts netted over a period as one approach a firm might take, and notes in the same breath that gains and losses in different funds cannot be netted.

The SEC has not published a formula for resolving every trade error, but it has set the test against which any netting arrangement will be judged. The Division of Examinations' published compliance questions for advisers ask whether trade errors are identified at the earliest possible time and resolved consistently with disclosures made to clients and the adviser's fiduciary relationship. The 2019 interpretation requires a conflict to be eliminated or disclosed fully and fairly enough for informed consent. Keeping a fund's error gains to fund the manager's own error losses is a conflict of exactly that kind, and if the offering document is silent the manager should not do it.

The SEC's 1998 inspection report on soft dollar practices records the staff position, set out in a 1988 no-action response, that correcting trading errors is not a brokerage service within Section 28(e) of the Securities Exchange Act. A manager therefore cannot have a broker absorb the cost of an error in exchange for order flow or client commissions. The cost is paid by whoever the policy says pays it, in money that belongs to that party.

The Error Log and Its Fields

The log is where the policy becomes evidence. A reviewer told that no errors have occurred in three years will conclude either that the firm has exceptional controls or that its definition is not being applied. The better answer is a log with entries in it. The fields should be fixed by the policy so that entries are comparable.

Two disciplines make the log credible. Near misses are recorded, because an order caught by a pre-trade limit is information about the control. And the log is periodically tested against the trade blotter, broker cancel and correct activity and the administrator's reconciliation breaks, because a log never reconciled to those sources cannot prove it is complete. The SEC's examination office published a risk alert on unauthorised trading on 27 February 2012 which identified unusual or high volumes of error account activity, including cancels and corrects, as a signal firms should monitor. The alert stated that its suggestions were neither a safe harbour nor a checklist.

Materiality, Investigation and Board Reporting

Not every error reaches the board. The policy should set a materiality threshold, as a proportion of net asset value, an absolute amount, or both, above which an error is reported to the governing body at its next meeting or sooner. Below it, errors are logged, resolved and reported in aggregate; there is no statutory figure in the Cayman framework. A lower threshold commonly triggers notification to the administrator, because an error that changes a published NAV is a valuation matter as well as a trading matter.

Investigation belongs to a function independent of the desk that made the error: compliance with the chief operating officer in a small firm, compliance with risk in a larger one. The portfolio manager provides the facts and does not decide the classification, the amount or the treatment. Unauthorised trades and restricted list breaches are investigated as conduct matters as well as errors. The February 2012 risk alert noted that many firms had adopted mandatory vacation policies without remote trading access, a control that is cheap and difficult to argue against.

For a Cayman regulated fund, the board's role is framed by the CIMA Rule on Corporate Governance for Regulated Entities, issued in April 2023 and in effect since October 2023. The Rule provides that the governing body must provide oversight in respect of the design and implementation of sound risk management and internal control systems, and must have access to accurate, relevant and timely information regarding the regulated entity. A trade error policy with a defined reporting threshold is one mechanism through which a board discharges that oversight; CV5 has described the wider agenda in the role of the fund board in hedge fund risk oversight. The board should receive a periodic summary rather than the log: errors by category, aggregate net amount, who bore it, open remediation and any entry above threshold in full.

The administrator sees the economic consequence in the fund's books but not the manager's classification unless told. The policy should specify that the administrator is notified of any error affecting a NAV that has been or is about to be struck and is given the manager's calculation. The reimbursement is then booked as a receivable from the date of the error rather than the date of payment.

What the Offering Document and the Expense Policy Must Say

Investors learn how errors are treated from the offering document, not from the policy, which most will never see in full. The offering document should state that the manager maintains a written trade error policy, that errors are corrected as soon as practicable, and how losses and gains are treated. Any standard of fault below which the manager will not reimburse must match the investment management agreement, and any netting across errors must be stated plainly. Silence is not neutrality; it is a representation that the default applies.

The expense allocation policy meets the trade error policy at the point where a loss would otherwise be charged to the fund. CV5 has set out in the expense allocation policy what a fund can pay for and what the manager must absorb, and error losses belong in the second category unless the fund documents provide otherwise. The cost of correcting an error, including brokerage on the unwind, belongs with the error rather than with ordinary transaction costs. Where a fund and separately managed accounts run side by side, an error is allocated across them under the trade allocation policy.

The policy should be short and its history kept. Reviewers ask for the current version, the date it was last reviewed and what changed. Fees, expenses and conflicts are recurring examination themes, and the fiscal 2026 examination priorities continue that emphasis for managers of offshore funds. A manager that can produce the policy, the log, the board summaries and the administrator's confirmation in one request has answered the examiner and the allocator with the same file. The wider package is described in how to pass operational due diligence as a new hedge fund.

Common Mistakes

• Defining an error by its outcome, so that losing trades become errors and profitable mistakes are never recorded.
• Promising reimbursement in the policy while the investment management agreement excludes liability for negligence, without saying which governs.
• Netting gains and losses across unrelated errors or across funds with no disclosure in the offering document.
• Leaving the portfolio manager to classify and price the error the portfolio manager made.
• Notifying the administrator only when reimbursement is paid, so the NAV in between is wrong.

Key Takeaways

• Write the definition first and define errors by the process that failed, covering execution, allocation, unauthorised trading, restricted list, guideline, third-party and model categories.
• State the default in one sentence, manager bears net losses and fund keeps net gains, and reconcile it with the standard of care in the investment management agreement.
• Permit netting only within a single error and prohibit netting across errors and across funds unless disclosed in the offering document.
• Fix the error log fields in the policy, record near misses, and reconcile the log to broker cancel and correct activity and administrator breaks at least quarterly.
• Set a materiality threshold for board reporting and a lower one for administrator notification, and report in aggregate below both.
• Cross-refer the trade error policy, the expense allocation policy and the offering document so that a reviewer reading all three finds one answer.

Frequently Asked Questions

Who pays for trade errors, the fund or the manager?

In institutional practice the manager bears the net loss on an error and the fund keeps any net gain. That default follows from the manager's duty to the fund rather than from a statute, and it can be varied by the standard of care and exculpation terms in the investment management agreement and the disclosure in the offering document. Reviewers read the policy together with those documents and expect them to agree.

What is the difference between a trade error and a bad investment decision?

An error is a failure of process: the trade departed from the instruction, the mandate, the trader's authority or a stated restriction. An investment decision is a trade executed as intended and within the mandate that then lost money. The first is dealt with under the trade error policy; the second is simply performance. A sound policy defines errors by the process that failed, not by the outcome.

Can a manager net gains and losses from trade errors?

Gains and losses from the same error are netted to a single amount, measured from the erroneous trade to the restored position. Netting across unrelated errors uses the fund's gain to pay the manager's liability, and netting across funds uses one fund's gain to cover another's loss. Neither should occur unless the offering document discloses the arrangement, and cross-fund netting is difficult to reconcile with the manager's duty to each fund.

What should a hedge fund trade error log contain?

Each entry should carry a reference and the trade, discovery, reporting and resolution dates, the category, and a description of what was intended and what happened. It should record the root cause, the accounts affected, and the gross gain, gross loss and net amount with the calculation method. It should then show who bore the amount and when, whether the materiality threshold was crossed and who was told, the remediation and its owner, and an independent sign-off. Near misses should be recorded as well.

When must a trade error be reported to the fund board?

There is no statutory threshold in the Cayman framework. The policy should set a materiality threshold, as a proportion of net asset value or an absolute amount, above which the board is told at its next meeting or sooner, with aggregate reporting below it. The CIMA Rule on Corporate Governance for Regulated Entities requires the governing body to oversee risk management and internal control systems and to have access to accurate, relevant and timely information. Error reporting is one of the ways that duty is discharged.

Does the trade error policy need to be disclosed to investors?

The offering document should tell investors that a written policy exists, that errors are corrected as soon as practicable, and how losses and gains are treated. That includes any standard of fault below which the manager will not reimburse and any netting the manager intends. Where the offering document is silent, investors are entitled to assume the default applies. The SEC's 2020 order against Franklin Advisers shows the consequence of a policy provided to a governing body and then not followed.