Monday, June 22, 2009

The 7 Habits of Highly Suspicious Hedge Funds

Note: This post will appear in The Journal of Investment Management

You've heard this story before: A trader at a bank is knocking the cover off the ball. His success garners political power within the bank. He creates a fiefdom that insulates him from the rest of the firm; his trading group explodes in size. He lives a conspicuous, extravagant lifestyle. His ego alienates the management and intimidates the support staff. Then the trader hits a rough patch. He uses all the tricks in the book to keep his poor results under wraps while he tries to find a way to recoup. Everyone is gunning for him, so he has to get back into the black, and fast.

How does he try to do that? He ratchets up his risk. He knows he won’t be able to turn it around fast enough if he plays it prudently, whereas there is some chance to stay in the game if he bets it all on 00, or better yet, if he levers up as much as he can, borrows all the money he can get his hands on, and then bets all of that on 00. If he loses, well, he was going to be gone anyway, so he may as well try for the big time.

That is one of the reasons there are risk managers. Risk managers know to put extra focus on traders who are struggling and, for that matter, on traders who seem to have an eerily hot hand. Especially if those traders have the ability to lever and to obscure their risk through the use of sophisticated instruments.

This story is now primed to play out in the hedge fund space. How many hedge funds do you know that more or less fit this description: A hedge fund manager had a run of great returns. His fund has grown by leaps and bounds. He has doubled his staff year after year in anticipation of even greater things to come. He has enjoyed a Page Six lifestyle; he is the belle of the ball, his dance card always filled. But now his kingdom is under siege. Assets under management have dropped precipitously due to redemptions layered on top of poor trading results. The investors that remain are demanding reductions in management fees. Incentive fees are gone until he scales the wall to get back to high water mark. With the way his operation has ballooned, he realizes that if he doesn’t make serious returns over the next few years, he will be crushed under the costs and the dwindling asset base.

What does he do? If he follows the same course as the trader at the bank, he will try to find ways to take on more risk. Of course, any investment fund might face the same temptation, but hedge funds have more tools at their disposal to make good on the try. Hedge funds can lever, delve into wide-ranging and risky markets and readily employ the so-called innovative securities to increase risk in ways that are difficult to discern. And unlike the trader at the bank, the hedge fund can operate without anyone seeing what it is doing. No one is looking over its shoulder at the trading positions each night.

Is the risk management in place to deal with this scenario? Here are seven “habits” that an investor should look out for:

1. No independent risk reporting.

One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. Or, at least, trust but verify. If things go wrong and that is what you relied on, you will look like a fool, or worse. The risk numbers must come from having a third party getting the fund’s positions and doing the analysis.

The risk reporting must go beyond the VaR numbers to include measures of leverage, concentration, degree of diversification and size in markets (to assess liquidity risk). Again, all independently provided.

The diversification and concentration are necessary because, as we now know all too well, the relationships between markets can change. These risk measures cannot be calculated simply by knowing how many markets the fund is trading. It is critical to know how linked the markets are; how concentrated positions are when aggregated across similar markets. With globalization, diversification opportunities aren’t what they used to be. And in any case, it isn’t much value to be active in twenty markets if two-thirds of the positions are in three or four markets that are closely related.

2. A change for the worse in the critical risk numbers.

When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports? For example, is the third-party view of leverage, liquidity or diversification as favorable as has been represented by the fund itself, both now and historically?

3. Increased use of derivatives.

In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and difficulty in marking means that they also can more easily hide losses. There should be extra concern if the fund has only recently decided to start using derivatives and swaps.

4. High level of secrecy.

Does the fund have a monolithic, scripted presence to outside investors? Does it obscure its approach with secret formulas and strategies? Does it invoke its need for secrecy to justify limiting access to essential risk information and to its production staff? If so, you might want to get ready for a Madoff moment.

5. Growth in headcount and lifestyle.

This is the firm’s equivalent of the trader’s lifestyle. The fund’s principles can stretch the envelope in terms of personal lifestyle, and, unlike their banker cousins, their firm is their own domain. They can get an “edifice complex”. If a firm has become bloated, if it has a growing cost base that forces it to be impatient, then it will be more desperate to swing for the fences.

6. Decline in assets under management.

This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

Related to this, is the fund far below high water mark? Hedge funds make money from fixed management fees based on assets under management and incentive fees based on the return they generate for their clients. Most hedge funds only start collecting the incentive fees after they get back to high water mark. If a hedge fund is thirty percent below high water market, it may need years of strong returns before any money starts ringing up in the incentive fee register.

7. Lackluster performance in recent years.

Most everyone was lackluster this past year. So you should look back at the recent performance before the 2008 debacle. A comparison of the performance over the past three to five years versus the performance in the more distant past can be an indicator of a failure of the fund’s inherent strategy. It could be that the space has become too crowded and competitive, that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. If things have been slowly petering out, if alpha has been diminishing, then more leverage and risk is needed to get back up to the target.

Or, in desperation, the fund might try something new. So a related phenomenon will be style drift or a move into new markets and strategies. Style drift can be an indication that the bread and butter strategy is not pulling its weight. Is there movement toward new markets, a.k.a. ‘new opportunities’. Is an equity fund hiring expertise to gear up in credit, is a macro fund starting to trade volatility?

Not everyone standing in the shadows is a mugger. And sometimes a cigar is just a cigar. Although "habits" like a lack of independent reporting are pretty obvious weaknesses, others, such as exploring new trading strategies, might be justifiable. But these are warning signs that justify deeper questioning and tighter oversight.


  1. Great post - I think there is an opportunity here for 3rd part reporting, but it would mainly be focused at managed accounts. The good news about this, in my humble opinion, is that we will probably see a significant migration from fund accounts to managed accounts. The managed accounts give the transparency that investors are looking for and much more as well as reduced expenses. Trying to get a fund to let someone come in and poke around at this level would be difficult (the fund would probably argue that you are trying to reverse engineer their strategy). But if its my managed account, the fund would never know and even if the fund did know you could tell them to bugger off.

  2. Managed accounts are certainly a way out of this. But it leads to transparency problems for hedge funds, because the person with the managed account can see what they are doing.

    So, for example, I could put a small amount in a great fund, look at my positions and then replicate it for free. Or if I were a competitor, I could trade against their positions -- squeeze their shorts, or pile into their growing exposures, thereby running the price up before they have fully invested.

    One way around this is to have managed accounts where the positions are only viewable by the client with a lag of, say, a month.

  3. Yeah, we ran across that problem about 8 years ago. Someone with a managed account who gets the reporting at T +1 can come a day away from replicating the strategy and the 1 day of lag time should beat the 2 & 20 fees. I hear your argument for hedge funds not wanting to disclose their positions (some positions are known , ask Brian hunter and John Arnold). But to me the bottom line is this. If a fund is going to ask me to trust them with my money they are going to have to trust me to see their position. As an investor I’ll sign an NDA or other legal doc that gives the fund some guarantee that I’ll keep the positions confidential and not go off and start my own fund. BTW- I cannot wait to read your book.

  4. These warning signs fit well into today's news. As I was reading, each one stood out to me as keywords for the recent happenings and ponzi's

  5. Excellent piece. This reinforces my opinion that a handful of people out there will be coming up with some truly innovative ways to structure funds in the future to mitigate these issues.

    (hint: I'm trying to launch just such a fund in a few months, and old-timer fund managers will hate how I deal with fees and transparency)

  6. Rick,

    I am delighted to have found your blog. I hope you don't mind but i have linked to this article from my blog. I am the founder/editor of a website dedicated to making investors more well rounded.

    Miguel Barbosa

  7. Rich - a sound and sensible assessment imho as a non-finance guy and it works well against your prior post on value-add by the hedgies. Steinhardt gave a WSJ interview (last year ?) that pointed out in the day that there were very few hedge funds and they enjoyed exceptional returns as innovators with good talent;but as the industry grew (too fast)the size, complexities and drying up of the talent pool would lead to poor performance. Which seems to be what's happening even without the kind of hard-nosed data you suggest.
    The other thing that strikes me about this post is home much it follows two classic general business syndromes. The hot hand startup that is out of control and the "widespreadness" of bad business practice as a result. In other words we got another sock puppet boom going here.
    Would you care to take a similar pass at the private equity industry ? For years the good returns have been top decile/quartile results while the rest were along for the ride. Current estimates are for at least 25% to go out of business. One thing I notice in particular is that despite the PR and protestations they don't actually pay much attention to the real business of their portfolio companies if they can avoid it. That seems to me be a differentiators between the possible survivors and the other 3/4 of the industry.
    Thoughts and reactions ?

  8. The absence of a substantial firm of accountants as an auditor would be a number one red flag for me.

  9. I wonder what your thoughts are on the high-water mark incentive scheme. Is it on balance a good or bad thing for hedge fund investors? Does not paying fees for losses to the NAV overcome the tendency to "swing for the fences" to get back into the black?

  10. First time view of the blog. Impressive background. I think the jist of the post is fine and correct, although to be fair this is standard fare for any fund of hedge funds and has been for years (yes, even before Madoff). Managed accounts are commonplace and becoming more so. If you want investment these days, you better be thinking about managed accounts. Transparency and liquidity are the key requirements for investors today. And the balance has definitely shifted to the investor post Madoff. firms that find managed accounts difficult to live with are the ones who have illiquid investments and cannot live with the withdrawal of capital - distressed debt etc. No manager wants a liquidity mismatch. And trading against positions, not sure about that. The investor would have to understand the trading rationale behind the hundreds of positions on the book to replicate the strategy. Needs knowledge and resources to do that. The investor tends to be downstream of the manager, e.g. pension fund, fund of fund rather than one of the peer group (although that does of course happen).