\"Can\'t regulate good judgment\" for hedge funds

Date: Thursday, February 12, 2009
Author: Mark Noble, Advisor.ca

The hedge fund industry grew too large, too fast, and too stupid — that seems to be the consensus of three hedge fund managers who thrived in 2008 and who expect the collapse of the world's current financial system to get rid of the losers.

Hedge fund managers with double-digit returns during the worst stock market crash in 70 years were panelists at an event organized by the Alternative Investment Management Association (AIMA) in Toronto. Ultimately they view the carnage in the marketplace as a means to weed out numerous hedge fund managers and strategies that have done much to tarnish the image of the industry.

Arguably the star attraction of the panel was Nandu Narayanan, the New York-based fund manager from Trident Asset Management, who manages the very successful Trident Global Opportunities Fund, which is offered to Canadian investors through CI Investments. The absolute return fund that uses a macro-investment style had returns of 35% last year.

Narayanan has risen to prominence as one of the first to predict the collapse of the financial system and the subprime mortgage crisis. He had phenomenal returns through relatively small allocations of his portfolio that were short financials and the complex debt instruments that proved their downfall.

He also expressed concern about stronger calls for regulation of hedge funds because he feels the biggest problem with hedge funds is that most are run by poor managers with a very short track record of success.

He balked at claims that regulators will be able solve the problem.

"You can't regulate competence, morality and ethics. There is only so much a regulator can do, and there is only so much transparency they can create. You can't regulate good judgment," he says. "The majority of investors lose their money in a legal way because the managers make stupid investment decisions."

He pointed to the Madoff scandal as a case in point, where prudent due diligence would have diminished the size of the fraud.

"There are crooks in this industry, as there are in any industry. Madoff was just one of the biggest ones. A bunch of rich people who didn't do their due diligence lost their money. Well, that's tough," Narayanan says. "That's what investing is about and that's why people conduct due diligence. There were feeder funds that got paid $500 million in fees for investing with Madoff. Well by George, for that you should be doing some due diligence. If you lose $50 billion because you gave money to a crook, because you didn't bother to ask him any questions, it's right that you lose money. Don't expect the regulators to come in and fix it."

In fact, Narayanan said, aside from the charities that were ripped off, he feels little sympathy for the predominantly wealthy individuals and institutional investors who were pulled into the scheme.

Indeed, there have been reports that some investors suspected Madoff's consistent returns were the result of "front-running" trades on which he had privileged information about beforehand — an illegal practice.

"There is analysis of the Madoff funds that he was either running a Ponzi scheme or he was doing something [else] illegal. Investors said if he's doing something illegal, that's great, we'll go make money anyways. There's some poetic justice to this," he says.

Narayanan is the first to admit that almost half his investment strategies fail — but the key is that he's doing something different, that's based on a lot of analysis and a disciplined investment philosophy that's been tested over time.

John Clark, CEO of JC Clark, attributes much of his success to his decades of experience and finding a discipline that works for him. He pointed out that a lot of hedge funds in Canada were little more than long-only mandates heavily invested in Canadian equities, which had a great run until the summer. He contends that many of these managers weren't doing their homework.

His JC Clark Preservation Trust was up 21% last year, partly due to a heavy weighting of shorts in the Canadian equity space. Currently, 30% of his market allocation is in short positions.

"We have the lowest gross exposure we've ever had in the history of our fund. We've been as high as 150%, where we are now looking at 80% [in the stock market]," he says. "Far too few investors paid attention to balance sheets. In many instances we are the only people who are short a certain [Canadian] stock in the world. We don't have crowded trades in our portfolios."

Due to the ban on shorting certain financial companies' stock, the industry isn't what it used to be, Narayanan pointed out. It's a development he called "nonsense" because he feels there is still a lot of pain to be felt in the financial industry.

"[These rules] made you become a criminal offender, because you were making money against fraudulent management," he says. "Somehow, because regulators failed to do their job and someone else tried to take advantage of this incompetence, it becomes a crime."

Narayanan says the U.S. banks are effectively "belly up" and the financial system is being reengineered to wipe out a lot of the complex derivative markets.

"The private sector plan [to buy troubled assets] is a way to dance around the fact that the banks are being nationalized right now," he says. "If you're working to deleverage the system, whole markets of these complex credit derivatives are going to cease to exist. That's going to be permanent. It's not going to be a market that's just going to come back tomorrow."

He could see this spillover effect having an impact on Canadian banks. From an investment perspective, he pointed out that the only good thing about the Canadian banks is that there are only six of them.

"A lot of them have complex instruments that they can't value that easily," he says. "If you want to buy banks right now, you're probably better off to go take a vacation in a mine field. You might survive — but you really don't know. In a relative sense there is probably value in Canadian banks, but in an absolute sense I wouldn't touch them with a ten-foot pole because I just don't understand them."