Avoiding Hedge Fund Fraud

Say you're a hedge fund investor who is uneasy with the idea of a manager who legally controls all the money that is entrusted to him. The solution could be a managed account, a trading vehicle in which the client retains formal ownership of his assets.

That's the conclusion of an academic study called "Mitigating Hedge Funds' Operational Risks," published by the Paris-based EDHEC Risk and Asset Management Research Center.

According to EDHEC, investors are often better off with managed accounts, whereby instead of ceding control of assets to a hedge fund partnership, the money is kept in a custodial account that is run by a professional manager. Both arrangements expose the client to an absolute-return strategy, but with a managed account the investor achieves a greater level of transparency.

"Managed accounts, when allowing independent risk control and independent valuation, will prevent a lot of bad things from happening," says Jean-Rene Giraud, author of the study.

In a managed account, the investor gets daily positions and independent reporting from the bank or an administrator. When pooling his money into a hedge fund, the investor has to live with monthly or quarterly performance numbers thrown at him by the manager.

While investors have little say on financial risk in a managed account, they can achieve a level of control over what is usually called "operational risk," a broad definition of pitfalls that are not directly related to investments. The term covers things such as fraud, an unpublicized change of strategy, mispriced assets and the misuse of leverage. To reduce operational risk, the report recommends a managed account.

How big a threat is operational risk? Significant, the study concluded. Looking at a sample of 10 hedge funds that shut down and returned money to investors (something that happens about 15 times a year), the researchers found evidence of the above-listed problems in eight of them.