The Ten Deadly Sins of Hedge Fund Managers

Date: Wednesday, March 16, 2011
Author: STUART FIELDHOUSE with HANS-OLOV BORNEMANN, SEB ASSET MANAGEMENT

Part of the skill of product development in the alternative UCITS hedge funds space is coming up with an approach that will address many of the fears and concerns institutional investors have about hedge funds. The best starting point then, for the would-be UCITS product development team, is a tour of the Ten Deadly Sins of Hedge Fund Managers, as compiled by Hans-Olov Bornemann, head of the global quant team at SEB.

It is important that this issue is viewed from two perspectives, namely that of the client and that of the manager. Investing clients will focus on the product, on its past performance, on the processes and systems it uses, on the people behind it (particularly the portfolio managers), and on the terms and conditions attached to that investment. This latter criterion has assumed even more importance in the wake of the hedge fund gating fest that was 2008. Clients will redeem funds for a combination of reasons: fraud or misrepresentation, the departure of key portfolio managers, poor performance, or a change in the risk profile of the fund.

Bornemann divides managers into two categories - type A and type B. In the case of your type A manager, while he can be described as “reasonably greedy,” he takes a balanced approach to his risk taking, a long-term view of his portfolio strategy and indeed the overall fortunes of his business, provides his investors with a reasonable level of transparency, and ultimately, according to Bornemann, he lives in the real world.

By contrast, the type B manager is too greedy, resorts to excessive risk taking, and takes a very short-term approach to his fund. He may either provide 100% transparency (handing out the exact recipe for alpha generation in order to get maximum inflows) or give no transparency at all (to avoid showing the risky positions), and ultimately can find himself living in a fantasy world of his own creation. The type B manager is driven by the personal goal of maximising his net personal worth as quickly as possible, and adopts a maximum fee approach to his business, leading to a priority placed on assets and returns in the shortest possible time frame.

Fraud
This brings us appropriately on to the ten deadly sins of hedge fund managers, the first of which is fraud or misrepresentation. While the classical fraud, which includes stealing money from clients, is most likely to get the hedge fund manager all the column inches he could ever want in The Wall Street Journal, there are more subtle frauds at work as well, including manipulation of the portfolio’s value, for instance by artificially boosting closing prices of illiquid securities that constitute major holdings of the fund or by putting unrealistically high valuations on hard to price instruments in the fund. Managers who play this game like those assets which require them to place a subjective valuation on them, or are dependent on their proprietary model for a valuation. However, there have also been cases where an external, ‘independent’ valuer has turned out to be not quite as independent as all that. Needless to say, the maestro of hedge fund fraud was Bernie Madoff.

Operational risks
All hedge funds face a range of operational risks on a day to day basis. These can include so-called ‘fat fingers’ where positions that are taken are too large, or too expensive, as well as problems arising out of NAV calculation. There are also counter party risks to take into consideration, and more recently the rise of US legal risks as a significant concern for some funds. Finally, the largest operational risk for an asset manager is the departure of key people as we have seen most recently with Gartmore.

Concentration risk
This is an area which may cause major problems for offshore hedge funds. Here the sinner is using too few instruments, or perhaps is concentrating on just a couple of sectors or asset classes. The temptation is great to concentrate the portfolio in order to increase returns, but it can lead to spectacular blow-ups. Within UCITS, there are clear concentration rules which try to limit inappropriate behaviour by the manager. However, if a UCITS manager really wants to concentrate the risk in his portfolio, he can easily do so by putting all the bets into a particular sector, country or asset class. In the offshore world, the hedge fund Amaranth made the mistake of concentrating its positions to the extent that it finally destroyed the firm.

Leverage
Next up we have leverage, which Bornemann segregates into net leverage and gross leverage. In the case of net leverage, investors should be concentrating on the manager’s net exposure to a specific asset class or risk factor, for example, net exposure to equities or to credit. For gross exposure, they should be looking at the fund’s gross exposure within an asset class. For example, how large are the aggregated long and short positions in an equity market neutral portfolio or in a foreign exchange carry trade portfolio? Strategies which require huge gross exposures in order to deliver noticeable returns are often facing huge liquidity risks.

Liquidity risk
Illiquid investments are always going to pump up the risk level of a hedge fund. However, you will never be able to gauge this risk by looking at the volatility of the fund. On the contrary, the measured volatility of the fund tends to be artificially low because of the illiquid nature of the investments. When nobody is buying or selling a particular security, the price of that security hardly moves and you get a low volatility measurement. The inherent risk of not being able to unwind your positions when you want to or when you need to, is, however, enormous. According to Bornemann, illiquidity is the most lethal risk factor of all and can be found to be the common denominator for basically all hedge fund failures (bar the fraud case). Dabbling in unlisted assets, small cap equities, off-the-run bonds, junk bonds, distressed debt or sub-prime credit may be associated with huge risks. Illiquid investments put your risk management out of order. The fund manager can end up as a paralysed rabbit in the headlights of the oncoming truck. There were plenty of sub-prime hedge funds that were killed because of illiquid investments in 2007 and 2008.

Funding risks
These problems arise with funds that are overly-reliant on credit lines of some kind for their strategy to work effectively. Funds get their funding from clients who invest in the fund, as well as from prime brokers who lend to it. Other potential funding risks can occur via securities lending arrangements. To be more precise, funding risk is the mismatch between the minimum guaranteed duration for your funding and the time it would take you to unwind your investments. Thus, strategies in lesser liquid assets should only be pursued if clients have been locked up and credit lines have been guaranteed for the relevant time frame. When it comes to funding risk, the largest sinners of all time are the banks, who seem to have a very short memory. However, leveraged fixed income hedge funds tend to be found in this category as well.

Too much AUM
To close or not to close, that is the question. Often, this problem can occur as the result of a good run by the manager, leading to considerable inflows. The portfolio manager is forced to expand his strategy into new markets and strategies in order to accommodate the new investments, and at the same time can find himself diluting his alpha. This all leads to higher risks, an eventual deterioration in performance, and finally redemptions and fund closure.

Copycats
This is less a personal sin for the hedge fund manager, and more a risk he faces from competitors. There will always be those firms who will seek to copy the best-in-class fund and even try to improve on it. This is not a very original idea, nor is it very new in this industry. What it does represent, however, is the very real risk that a fund will suddenly find itself participating in crowded trades, having its alpha diluted and being exposed to potential market dislocations. This is also a risk for those big funds that lose key portfolio managers, talented individuals who have studied at the feet of the master, but who can then launch their own funds. If their approach to investment is similar to that of the shop where they learned their trade, they can fall into the copycat category. In many respects, it can be more rewarding to keep your portfolio managers close and not give them cause to go out into the big wide world to do their own thing.

For model based strategies, being too transparent about the model is a manager sin. Goldman Sachs Asset Management’s quant team made this mistake and were caught in the quant melt down in August 2007. Two and a half years later, their $7 billion hedge fund, GEO, had to be closed down.

Being front run
This is a problem that can happen to hedge funds that have become larger than they should. According to Bornemann, financial predators, i.e. trading desks of investment banks and aggressive hedge funds, eat wounded elephants for breakfast. “Why chase and eat elephants?” he asks. “They are easy to discover and they are slow moving. They paint themselves into corners, making themselves easy prey. When two elephants are fighting, you get one prey for free! And when elephants fall, they create massive market impact, and more profit potential.” The brutal law of nature assures that large hedge funds that get wounded will get killed in the end by other market participants. The prospect of an elephant feast is too appealing for these predators. In other words, hedge funds should avoid becoming the elephants in this scenario, and work more on being nimble predators in the market. When funds get too large, they do begin to resemble ambling great beasts.

Forced unwinding
There can be a range of factors prompting a fund into a forced unwinding scenario, amongst them losing positions, margin calls, new margin calculations, reduced lending, and client redemptions. Losses in illiquid instruments, increased market volatility, and being ‘front run’ can also contribute to this. It is not a nice place to be. Unfortunately, since humans tend to act in one and the same manner, a number of these factors tend to coincide from a temporal perspective. Moreover, hedge funds running similar strategies tend to be treated in the same way by their stakeholders. At some points in time, nobody wants to be exposed to risky assets. Thus, unwinding becomes a systemic phenomenon.

A deadly failure - Long Term Capital Management
As a case study for the Ten Deadly Sins, Bornemann chooses LTCM. On the surface of it, the US-based hedge fund had put together an outstanding portfolio management team, consisting of the arbitrage group from Salomon Brothers, and two Nobel prize winners, Robert Merton and Myron Scholes. Between March 1994 and April 1998 LTCM had a track record of 32% per annum gross, and 90% of its monthly NAVs saw it in positive territory. At the end of 1997 the partners returned $2.7 billion to outside investors, but kept their own money in the fund ($1.9 billion, or 40% of the fund’s NAV).

It is fair to say that LTCM committed most if not all of the Ten Deadly Sins: concentration risk, leverage, liquidity, funding and forced unwinding were all issues with the fund. It also suffered from excessive AUM issues, being front run, and having to compete with copycats. It ended up being the most spectacular hedge fund blow up of the decade. However, Bornemann asserts, any hedge fund failure can be analysed from the perspective of the Ten Deadly Sins of Hedge Fund Managers and you will get a high score in almost all instances.

Conclusion
The point of this exercise was to help both clients in their analysis of hedge funds and product developers in their process of creating customer friendly funds. The immense popularity of the UCITS III law can be explained by the fact that it tries to both protect the end investor from the most obvious kinds of mis-management and also allows the fund manager to use modern investment techniques, e.g. to go long and short using derivatives.

Although the UCITS law and the fund prospectuses are doing a good job in setting the outer limits of what a fund manager is allowed to do, clients still need to conduct a proper due diligence of the asset manager and the investment team.

Bornemann advises clients to put less weight on company brands, titles, fancy systems, size of organisations and other glossy or superficial elements. More time and effort should be spent in understanding whether a fund is investing in liquid or illiquid instruments, how any potential capacity limit of the fund has been determined and to what extent the fund is concentrating its risk exposures or not.

It is crucial to understand how the risk management process works in practice and what kind and how much leverage the fund is using. Was it because of the historically high Sharpe ratios due to long positions in credit or alternatively short positions in volatility, i.e. games that look good for four to five years and then blow up in your face, or has the performance been achieved with low correlation to equities and other risky assets? How did the strategy perform during periods of major market distress, e.g. in 2008?

Past performance is only as good as your understanding of how the performance was achieved. Was it the manager or was it the market who delivered the good returns? Was the manager lucky or was he acting in a prudent and systematic way?