© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the November 2005 edition of BENEFITS CANADA magazine.
Hedge fund investing is becoming more popular with individual and institutional investors. But there are bumps on the path toward the investment.

“Manage the risk and the returns will come,” is an oftcited adage in the world of alternative investments. The problem in alternative investments, however, is they are at the cutting edge of risk. It is perhaps in the nature of the beast, but it seems that for every new source of return hedge funds discover, they seem to turn up a new risk.

For exactly that reason, it’s impossible to offer a compendium of hedge fund pitfalls—hedge fund managers regularly endure 50-page due diligence questionnaires as well as numerous on-site visits before they are accepted by a fund of funds. There are, however, ways of managing those risks, including the prudent person rule: diversify.

Let’s put that in context. Hedge fund managers are active managers; they incur the same risks as long-only or traditional asset managers. For pension funds, the most prominent risk over the past three decades has been that a selected manager has an unacceptable tracking error: they underperform a benchmark.

Lately, another risk has emerged; pension fund advisors with a significant retail mutual fund presence can fall afoul of the regulatory authorities. This can happen by paying for “shelf space” so that brokerage firms will recommend a manager’s funds, or by permitting day-trading, something that is not, in itself illegal, but which may violate what a fund manager declared in its prospectus. Whether legal or not, day-trading settlements have prompted an exodus of assets under management in the U.S., something that trustees must also worry about.

That’s a crude encapsulation of what pension fund trustees face with traditional investment advisors; either they don’t perform, or they suffer a taint on their reputation, a “headline” risk. These risks are not unknown in the alternative investment industry.

But, in addition to these risks, hedge funds incur a separate set of risks, largely because they are small, entrepreneurial shops, exploiting market niches that don’t have a predictable risk profile. Those market niches can indeed be profitable, given the right manager, but precisely because they are outside of the mainstream, they incur risks that trustees will probably not have met before. A broader framework of risk is required, one that considers performance as well as operational risks.

Every hedge fund strategy, for example, has a cyclical element to it. Indeed, MacFall Lamm, chief alternative investment strategist at Deutsche Bank in New York, has given a series of presentations on “dead hedge fund strategies,” strategies that may falter thanks to trends in equity and bond markets. While hedge fund managers strive for uncorrelated returns, they still depend on activity in the general marketplace. Thus, to call them “absolute return strategies” is a misnomer. They don’t always make money.

Should that be a concern? Pfäffikon, Switzerland-based Claude Porrot, who seeds up-and-coming hedge fund managers at RMF Investment Management, a Swiss-based subsidiary of one of the world’s largest hedge fund managers, the Man Group, has stop losses. If a fund loses 10% in a relative value strategy, or 20% in a directional strategy, she’ll pull the allocation. But before doing that, she’ll make a peer group comparison. If the whole category is suffering, then that may not be a reason to fold the investment.

Adds Clive Morgan, a principal at York Investment Strategies in Toronto, “if a manager’s in the range, then there’s no problem. But if he’s outside the range, it’s a real red flag. He gets a phone call.”

Porrot has an interesting vantage point. “Young managers in their first years tend to have higher returns than older managers,” she notes. That’s in part because they can take advantage of niche opportunities. Still, many investors shun newer managers, demanding at least a three-year track record.

A three-year track record is no guarantee of future success, but it may give some confidence of a sound operation. Porrot notes that 78% of hedge funds fail, not because of poor performance, but because they couldn’t manage their business.

Many hedge fund managers come off the trading desks of banks. There, they were backed up with the bank’s own capital. Once in business for themselves, they don’t have that kind of capital. Even with $50 million in assets, a hedge fund would still be a two- to four-person shop. Once it gets to about $100 million, it can start building out the corporate infrastructure and become a functioning hedge fund firm.

Robert Cultraro, a consultant with Aon Consulting in Toronto, suggests using a “people, philosophy and process approach to due diligence. That means not only getting managers to identify their “edge,” that is, how they make money, but also understanding how the organization works. “Multiple roles cause distractions, “ he adds.

Operational risk can shade into fraud. “Out of any 1,000 funds that are formed, there’s going to be one or two that are going to be frauds,” says Texas-based author and hedge-fund consultant John Mauldin. Lately, the U.S. financial press has been poring over the remains of Bayou, a $400-million fund that allegedly falsified its returns back to 1996. What Bayou, and indeed, a number of other hedge fund busts teach, is the importance of certifying the reliability of thirdparty service providers.

“If we’re putting client money in, then I want to see the money, I want to see the prime brokerage ticket,” says Mauldin. That depends on having independent service providers, including a custodian, administrator, auditor and legal advisor. In the Bayou scandal, a related party was doing the fund auditing. And Mauldin points out, regulation would not have prevented that. Bayou did its trading through a related unit, Bayou Securities, which was a securities registrant.

An independent auditor is important. So too is an independent administrator, who sets the net asset value of the fund. Some funds in the U.S. have come to grief because they valued their assets themselves. Neither of these two risks is unique to hedge funds. At least two mutual funds companies in Canada have faltered, one through manual pricing of securities, the other through falsified audit records.

The independence of the third-party providers is something Morgan stresses. “Who is the custodian,” is one question he asks. Another is, “Does the manager have the right to access the money, except for the management fees?” Says Mauldin, “Funds that I would have recommended four years ago I won’t, simply over transparency issues.”

Another risk investors face is when a specific investment fails. Instead of writing it down, a manager may give it time to recover. In the interim, however, it is an illiquid investment. “If you have an event, that part of your fund will be frozen,” explains Bernice Miedzinski, a principal at York Investment Strategies in Toronto. That investment will likely be moved into a separate share class, with no immediate prospect for redeeming.

Another risk that has come into focus concerns sideletters. They are called that because the manager doesn’t want to change the offering memorandum, notes Gary Ostoich, president of Salida Capital and a partner at McMillan Binch Mendelsohn in Toronto. Managers, eager for large allocations from institutions, may make special deals that could affect other investors. A large investor, for example, may insist on the right to redeem funds if there has been a major change in the organization, such as a key person leaving. A key consideration for investors is whether such arrangements have been disclosed, and whether it’s actually enforceable.

When it comes to hedge funds, risk management is an emerging discipline. “It’s important not to take things for granted,” Ostoich warns.

Scot Blythe is the editor of Advisor’s Edge Report. Scot.blythe@advisor.rogers.com

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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