From the October 2007 issue of Boomer Market Advisor • Subscribe!

October 1, 2007

Boomers and hedge funds -- Is the risk worth the return?

The demise of a handful of hedge funds in 2006 thrust the issue of risk firmly back into the limelight. There were two primary causes of the most high profile hedge fund collapses of 2006: fraudulent activities and incorrect market calls. The first should be easier to control than the second.

Seeing the signs -- Fraud is enabled by the lack of proper operational controls in the funds and their managing companies. The increasing maturity of the hedge fund market, the higher levels of institutional participation and the increasing influence of funds of hedge funds in recent years have raised the bar significantly in terms of operational integrity of funds across the industry. Adopting best practice operational controls - such as external pricing validation, financing oversight and accounting audit - is largely up to the funds themselves to decide upon. The fact that most funds are voluntarily adopting such controls highlights how important this issue is to the industry. There is still significant disparity in regulation of hedge funds around the world. For instance, funds registered in Europe are required to appoint an independent administrator; however, this is not a requirement by U.S. regulators. Recent scandals have contributed significantly to the debate on the level of regulation that should be imposed. Although the outcome of this debate is still uncertain, steps in the right direction are discernable.

Identifying winners -- Incorrect market calls were second reason for several of the high profile collapses in 2006. It's a danger in any active investment strategy. However, the magnitude of some of the losses, particularly in strategies that use sophisticated financial instruments, that caused debate over the appropriate level of risk managers take. This debate has focused on the amount of transparency and insight that both investors and regulators should have with hedge funds. There is only a limited amount of risk mitigation that can be applied when identifying manager talent. This is one of the principle objectives of any investment due diligence a prospective investor performs on a manager. Even when an investor has chosen a talented manager, there is still the risk that the investment strategy could go wrong. This is especially the case when considering abnormal or extreme market events, such as those the sudden withdrawal of liquidity from the equity markets in May and June of 2006. We cannot predict the timing or magnitude of extreme events; however, we can mitigate extreme event risk by understanding it. Specifically, this can be done through gaining a level of transparency with hedge funds that enables the investor to fully understand the investment strategy and level of risk.

Gaining clarity -- The right level of transparency is one of the central factors to the current market debate. From an investor perspective, there is the question of whether they would actually benefit from seeing the underlying positions in a portfolio. From a manager perspective, there is understandable resistance to permit a high level of transparency to investors who may not be able to use it meaningfully. But, they are increasingly willing to provide this level of detail to sophisticated institutions and funds of hedge funds that use it constructively. But finding the right level of transparency with managers is not a straightforward exercise. Investors can control transparency risk to an extent. They can do so by ensuring they understand and are happy with the philosophy that drives the manager's investment approach. They can also ensure they have a high level of understanding of how the manager implements the strategy and be very secure that their expectations from the strategy are reasonable. Finally, this must all be underpinned by a strong belief in the investment skill and operational integrity of the manager in question.

*For further information or to contact this author, please use the forum below.

Reprints Discuss this story
This is where the comments go.