The key base for hedge funds: propriety

Date: Monday, June 2, 2008
Author: Brian Milner, Globe and Mail.com

Hedge funds have turned into the market's favourite scapegoat, blamed for just about every conceivable ill wind blowing through the global economy, from skyrocketing energy and food prices to the woes of Wall Street investment banks, the mortgage mess and speculative assaults on the Icelandic krona.

Just this week, the ever-vigilant folks at the U.S. Commodity Futures Trading Commission went public with the news that they have spent months looking into whether there has been any illegality in the rapid runup of crude oil prices. They need look no further than the profiteers who run OPEC for their answer. But chances are they hope to unmask an evil schemer sitting in front of a computer screen in a non-descript office somewhere.

So far, they haven't had any luck.

But there's plenty of other stuff not to like about the way many hedge fund players go about their affairs. These include exorbitant fees that may have little to do with actual performance, a lack of regulatory oversight, often opaque practices and apparent conflicts of interest.

None of this mattered quite so much when these private pools of capital were much smaller and for the super-rich. But how hedge fund managers run their businesses today, including how much they charge, who determines the value of their portfolios and what they choose to disclose, matters a great deal to millions of ordinary people whose pension plans in Canada and elsewhere are pouring billions into these alternative investment vehicles.

As recently as 2000, the entire industry controlled about $450-billion (U.S.) in assets. The total now is north of $2-trillion, with another $16.5-billion added in the first quarter.

Enter a low-key British expatriate named Chris Addy.

You have probably never heard of him or his small Montreal firm Castle Hall Alternatives.

But the hedge fund industry certainly has. He was recently named by Institutional Investor News as one of the 20 rising stars in all of hedge land, even though he manages no one else's money.

What Mr. Addy does is analyze the business side of hedge funds, poking through back offices to assess their not inconsiderable operational risks for private clients ranging from pension and endowment funds to family trusts. His firm is, in effect, a rating agency for the industry, except that he's only paid by the investors who hire him, not the hedge funds, and he doesn't care what investing strategies the hedge types employ or even whether they make money.

What he does care about is whether there are proper financial controls, internal checks and balances, and independent valuation of the portfolio.

"One of the paradoxes we see is that on the one hand, hedge funds can be astonishingly complex in the sense of the instruments they trade," Mr. Addy said the other day between sips of decaf. "Yet at the same time, these are very, very small businesses."

Not surprisingly, then, the infrastructure and in-house oversight that investors have come to expect from major financial institutions are often simply not present.

Another negative is the lack of price competition. Most funds use the same standard formula. The 2-per-cent annual management fee is bad enough, but it's the 20 per cent on top of that as a cut of any supposed profits that really rankles.

"Hedge funds pay themselves every year on paper profits," based on the rising book value of the portfolio, which they themselves may be determining, Mr. Addy notes, in describing what he regards as the biggest operational danger of all. "Obviously, there is a massive conflict of interest if the portfolio manager marks his or her own book. It's a wonderful game if you can get it."

Yet although he sees plenty that needs fixing, Mr. Addy firmly believes in the industry's long-term staying power as a valuable source of diversification and returns for institutional investors.

"If I'm an investment analyst and I take 100 stocks and rank them in order and decide to invest in the best 10, then I'm only using half my information. Presumably, I also know the worst, so why not profit from that?" Which is where hedge funds come in.

And when used properly, they do what their name suggests, reducing overall risk. Indeed, they may well be safer than traditional equity products at times like these.

So hedge funds are only going to get larger and more influential. The trick is to pick those that devote as much attention and resources to good management practices as they do to their trading strategies.