From the April 2006 issue of Wealth Manager Web • Subscribe!

April 1, 2006

Look Closer

Security expert Bob Strang well remembers the time his company was hired to investigate the CEO of a private equity partnership who was purported to be a rabbi, an attorney, and an accountant.

"Absolutely none of it was true," says Strang, a former FBI employee and U.S. Drug Enforcement Administration agent who has since turned his talents to the corporate world. Strang is CEO of New York-based Investigative Management Group, whose roles run the gamut from anti-terrorism work for the New York City subways to financial due diligence on behalf of lenders and private investors. His team routinely scours criminal records, business affiliations, as well as legal, tax, and bankruptcy filings in order to unearth the truth about hedge fund managers and private equity principals who may promise hefty returns while saying very little about how they're actually produced.

The "rabbi" in question had been lying and getting away with it for 20 years, says Strang. Not this time. "One thing after another didn't check out," explains the high-end gumshoe, whose sleuthing prevented Strang's client from entrusting a con artist with roughly $200 million.

Using a private investigator to uncover dirty laundry at your favorite hedge fund of funds may be a bit of a stretch for some financial advisors--although some do hire them. The point is, it's not always easy to establish with certainty that the seemingly attractive privately traded REIT or hedging strategy you've had your eye on is entirely above board. "More and more people are getting involved in alternative investing," says Strang, and at lower asset levels, increasing the pain when a strategy does go bust. It's not just the little guys who may be in over their heads, however. This is an issue that has begun heating up even for prodigious pension fund investors, which, along with other large institutions, are expected to inject as much as $300 billion into hedge funds by 2008--up from only $5 billion ten years ago, according to a study by the Bank of New York and Casey, Quirk & Associates that was quoted in a New York Times cover story last November.

What's most important is knowing why you are reaching for that alternative investment in the first place, planners maintain. As any advisers worth their salt can tell you, generating consistent outperformance is not the Holy Grail of hedge fund investing. "The key to hedge fund investing is to fully understand that you are integrating the hedge funds into a portfolio not to boost performance as the primary objective but as a tool designed to reduce overall risk," says Brad Stark, MS, CFP, CMFC and AAMS and co-founder of Mission Wealth Management in Santa Barbara, Calif.

The key phrase there is "reduce risk."

Stark's average client is 58 with a net worth of $5 million, and the firm works diligently to invest 10 percent to 15 percent of each and every one of its client's assets in some kind of alternative investment, using hedge funds for the most part and usually dealing with one of four multi-strategy "fund of fund" hedge fund vehicles "that are really going to the nth degree to follow regulatory oversight issues by licensing themselves as registered products with broker dealers and the SEC. Beyond that, new SEC requirements calling for hedge fund advisors to register with the agency as investment advisers could add some credibility to the business, says Stark, who currently has client money in such vehicles as the Oppenheimer Tremont Hedge Fund Series, a fund of funds comprising roughly 30 hedge strategies under one umbrella. Other broker-dealers with hedge fund offerings include Charles Schwab, Goldman Sachs, JP Morgan, Bank of America and Morgan Stanley.

"What really caused us to take a look at hedge funds in general was 9/11," says Stark. "Your standard mutual funds tend to take long positions only. If something horrific were to happen again, at least hedge funds have the opportunity to short the market and potentially offset the volatility of traditional investments."

"It is a fallacy that all hedge funds are extremely risky," says an article that appeared in Mission's 4th Quarter 2005 Investment Review. Moreover, "When multiple strategies and managers are properly coordinated together, the volatility can be relatively low," according to CFP Geoff Gaggs, Mission's client relations director and author of the quarterly review, which explained that hedge funds offer a possible low correlation to traditional investments, allowing them to "shine when other aspects of the portfolio are out of favor."

Still, Stark says that one must tread carefully in this underregulated arena, as there are clearly some "cowboys out there doing whatever they want and calling themselves a hedge fund."

What's an adviser to do? "It is important for full background checks to take place on the people running the hedge funds and to look at their past business dealings, any regulatory missteps, past performance or questionable past endeavors," Stark explains. Fred Whaley, managing director of Raymond James' alternative investments group in St. Petersburg, Fla., says Raymond James has a team of 10 people handling due diligence for high net worth clients, typically those with a minimum of $1 million in assets.

When it comes to judging performance, you'll want to see a track record, says Whaley. You'd be more likely to have faith in a manager with four to five years of experience running the fund. Assuming the fund was touting a 12.5 percent compounded annual return over the last five years, the question would be: How did you get those returns? Have managers stuck to their original plan, and is this a methodology that can produce those types of returns in the future? Whaley would also want to evaluate several qualitative factors by analyzing the fund's management team, as well as its prime broker and accountant.

Whaley's group typically spends a year on due diligence and monitoring before recommending a hedge fund or other investment vehicle to the Raymond James investment committee for approval. Raymond James will also talk to the management team on a monthly basis and do full reviews twice a year.

Of course, "We'll visit them in person a number of times in the initial due diligence period and probably at least once a year during the period while we continue to offer their product," Whaley says. Raymond James thinks it best not to commit more than 5 percent of a client's portfolio to any one alternative investment, though several different vehicles might be used to bring a high net worth individual's total investment to 15% of the portfolio.

All well and good, you may be thinking, but how do you really know when something is amiss with a hedge fund manager or private equity partnership principal? Red flags, according to Strang, would include an undisclosed bankruptcy within the last 10 years.

There are a number of public record indices available, including Lexus Nexus, that may help an advisor to learn of such an event, but keep in mind that such indices may drop information about a bankruptcy after a period of seven or eight years.

The same goes for an undisclosed DWI. Battery towards a spouse, while not always easy to uncover, is another signal that you may not want to entrust your money to the individual in question. A history of lawsuits can also be a deal-breaker. Certain counties have free Web sites offering information about litigation, Strang observes--in New York, for instance, a site known as ACRIS will show you whether there is a judgment against an individual and whether they own real property in New York City. (www.nyc.gov/html/dof/html/jump/acris.shtml).

Finally, nothing may be as valuable as going to see the fund manager yourself. Jon Lukomnik, a well known hedge fund expert and a former New York City official charged with overseeing roughly $80 billion in defined benefit pension plan assets, notes there are lots of data bases and a number of firms able to "slice and dice" the data for you. "Here's the problem," says Lukomnik, now Managingnow Managing Partner at Sinclair Capital, a consultant working with investors as well as hedge fund managers. "The best estimates identify somewhere between 8,000 and 11,000 hedge funds in existence and no requirement for any of them to report to any database. The information can be very useful, he says, nevertheless it is also entirely "self-selected."

Beyond that, "This is very different from an investment in a mutual fund where you are researching printed material, Lukomnik continues. "The labels which are slapped onto hedge funds, such as relative value, are just not as definitive as those slapped onto traditional money managers. There are shades of grey that approach white and approach black."

Moreover, "A good hedge fund is supposed to be an all- market vehicle. By definition, it has to do different things in different marketplaces. Because the investment strategy is not as stationary as with a mutual fund, to understand the philosophy of the hedge fund, you've got to talk to them directly," says Lukomnik, and preferably, in person.

In short, you can't trust an investment, if you can't trust the manager.

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