Investors advised to do their homework on hedge funds

Date: Monday, September 21, 2009
Author: Dian Vujovich, Palm Beach Life

When the stock market is soaring and your I-want-a-big-piece-of-that meter goes full tilt, it's easy to be duped. Especially if you're the kind who is easily seduced by the not-for-everyone stamp that's a very real part of investment products such as hedge funds.

But as the markets over the past year have reminded everyone — no matter how much money they have to invest — is basically that what goes up also comes down. And sometimes that down part is particularly ugly.

There's no need to rehash Bernie Madoff's hand in ruining the financial lives of many individuals and charitable organizations. Nor how the KL Financial hedge fund, managed by John Kim, Yung Kim and Won Lee right across the Intracoastal in West Palm Beach, lost $194 million. What is worth looking at, however, is that with research and homework on an investor's part, sidestepping hedge funds run by the horrible can really be avoided.

"What keeps me up at night is, of course, fraud," says Paul D. Pomfret, managing member of PDP Capital Investments in Palm Beach and manager of two hedge funds. "I can choose managers that are diversified (for his fund of funds' portfolios), but the one thing I can't diversify away is fraud."

Fraud, as it turns out in the world of hedge funds, isn't that impossible for potential investors to detect. All an interested hedge fund investor need do is take the time to request and read the information they receive, and then verify it.

"It kills me when people haven't done that," says Evan Rapoport, co-founder of Hedgeco.net, a hedge fund database and hedge fund services provider in West Palm Beach. Finding fraud, he said is "so easy to catch."

While there's no way to guarantee that any investment, hedge fund or otherwise, will make its investors any money, there are a few red flags that stand out in the hedge fund arena. Pomfret and Rapoport point out a few and suggest all investors take the time to research each:

* The auditor. Pomfret: "The first thing you want to do is find out if all the information you've been given is correct. So what you do is review its audits. That would have saved you from Bayou's Hedge Fund where they made up an accounting firm."

Rapoport agrees. He suggests reviewing audits from the fund's last three years.

A hedge fund's auditor doesn't have to be one of the biggest firms, such as Deloitte & Touche, but it does have to be an independent accounting firm with more than one client.

* The legal arm. Is the firm that's putting together the hedge fund's documents reputable? Ask questions such as how long the firm has been in buisness, who its other hedge fund clients are and what kinds of costs for its services are involved.

* The prime broker. If a hedge fund trades equities, its prime broker is the firm that is the custodian of the firm's money and prices the fund's securities at the end of each month. Having a reputable prime broker is very important.

And because a prime broker prices the fund's holdings, it also can prevent a fund from manipulating the prices of the securities it holds.

"An established prime broker can stop the hedge fund from artificially manipulating the market and charging excessive commissions, " adds Pomfret.

* The administrator. Likely the most important flag in this grouping is who the hedge fund's administrator is.

Administrators watch over the bank account of the firm, act as a watchdog for the movement of cash in the fund's account, watch over the firm's brokerage account, keep the books and records for the funds, and prepare everything for the firm's annual audits.

Why is all of that important? "It's important because you've got somebody watching over the fund on a month-to-month basis so if something does not look right, the administrators would know this immediately, and then would question the management of the firm and inform its investors," explains Rapoport.

"Madoff," he adds, "didn't have an administrator."

If all of this sounds too daunting a homework project, and a lot like doing your own due diligence, you are.

Hedge funds, remember, aren't regulated.

Their total number can't be verified, although it's estimated to be somewhere between 8,000 and 12,000.

Finding out the past performances on each is tricky because to do so, one has to be an "accredited investor" i.e, for the past two years have income of $200,000 or more for those filing singly or $300,000 for those who file joint returns, and have more than $1 million in liquid net worth.

Plus, because SEC rules prohibit hedge funds from advertising their performances, getting that information requires individuals and interested investors to register, answer a number of questions and become a member on any Web sites providing specific hedge fund performance data.

One way to shorten the research, however, is to invest into a fund of funds.

Their managers have already done their own due diligence, said Rapoport, who estimates there currently are about 2,300 funds of funds. (The two hedge fund offerings from PDP Capital are funds of funds.)

In the end, as with everything else that has to do with our money and how or where we choose invest it, it comes down to checks and balances.

Those looking to rebuild their coffers would be wise to keep that in mind.

BIG FAT HEDGE FUNDS

Hedge funds have been around since 1949. They have their quirks — such as little regulation and impossible-to-get up-to-the-minute performance figures. Still, billions have been invested in these vehicle. Here are the 10 largest, as of June 30, 2009:

NAME, Assets (in billions)

UBS Global Asset Management A&Q, $31.43

Man Investments, $26.4

Blackstone Alternative Asset Management, $25.07

Union Bancaire Privée, $23.83

HSBC Alternative Investments, $22.27

Goldman Sachs Asset Management, $21.4

Grosvenor Capital Management, $20.3

Permal Investment Management, $18.7

GAM Multi-Manager, $16.1

Pacific Alternative Asset Management Co., $15.63

Total, $221.13

Source: InvestHedge and www.plansponsor.com