Seeing in the Dark
Emma Trincal
09/01/05 - 06:57 AM EDT
Funny thing about hedge funds. Sometimes the more forthcoming a manager is, the less you want to trust him.
Connecticut's embattled Bayou Fund doesn't currently rank as a bastion of transparency, but it did once. Bayou manager Samuel Israel was famously gregarious, showering investors with information, emailing weekly performance reports and telling anyone who would listen how great he was doing. Israel trumpeted annual returns that supposedly blew away most of his peers.
Now, the shades are pulled, and Israel has shut his mouth. State and federal prosecutors are investigating what happened to up to more than $400 million of client assets that some investors worry went up in smoke.
Don't trust appearances. Most hedge funds take the maxim to absurd lengths by giving virtually no appearance to trust. While they may give occasional valuation updates (monthly, quarterly, yearly), they are under no obligation to explain their trades or to disclose their underlying positions.
In short, most hedge funds are opaque -- and that's how clients prefer it.
"The hedge fund that are good don't want to bother with transparency," says Jim McKee, a consultant at Callan Associates who advises investors on managers out of San Francisco. Good managers believe disclosure erodes returns by tipping their hand or orienting performance to short-term goals.
Top managers tell their clients, "Trust me, the less you know about your investment, the better your returns will be." In a world where the best funds become closed to new investment almost immediately, it's a covenant that usually must be accepted.
So how are investors supposed to pick winners among the 8,000 hedge funds out there? When return is a direct function of talent and strategy, the question is an important one. Too much emphasis on a manager can leave you in unsuitable strategies or undiversified, while too little can lead to poor performance or worse.
Who is responsible for the investor's money? Ultimately, the investor. But investing in hedge funds is usually done through a complex chain of players that may or may not have the investor's interest at heart. Hedge fund marketers, for instance, get paid by hedge funds to round up investors. Hedge fund consultants collect a fee from investors, but might have hidden incentives to drive them to a particular fund or group of funds.
Because hedge funds are so lightly regulated, an investor who runs into trouble has limited recourse. A marketer who fails to disclose a fee arrangement might be committing fraud, but because marketers are often not broker dealers, the
NASD has no jurisdiction to enforce claims.
Much due diligence in the hedge fund industry is done by fund-of-funds managers whose task is to select a pool of good choices and invest their clients' assets in them, like mutual funds select the best stocks. Funds of funds usually have a team of analysts who screen managers and monitor performance.
Fund of funds researchers evaluate returns and make sure managers are in sync with the strategy they are supposed to employ (to prevent "style drift"). This kind of due diligence reportedly helped some investors get out of Bayou before the ship sailed.
Still, most sophisticated investors insist on much more than quantitative analysis. They want their representatives to act like detectives, checking the background of a manager, his work affiliation, his resume, former colleagues, court records, public documents -- even his private life. The investigation can go as far as checking the manager's relationship with his spouse and partners. In some shops, divorce is considered a red flag. Conflicts with employees or partners are warning signals.
"I know this is a biased, self-serving statement, but I don't think funds of funds are equipped to do people due diligence on their own," says Randy Shain, executive vice president of BackTrack Reports Group, an intelligence division of First Advantage and a company that specializes in conducting investigative work for several dozen funds of funds.
The case of Bayou shows how difficult the vetting process can be. While there were some minor discrepancies in Israel's story (an allegedly exaggerated resume and links between a fund principal and its auditor), they were difficult to spot.
"This is a guy who had a family. His grandfather was a legend," says Ken Raisler, a lawyer who heads up the hedge fund practice at Sullivan & Cromwell. "The guy was well-known. He did not come off from under a rock."
Even a $7,500 fine paid by Bayou's broker dealer, Bayou Securities, to the Connecticut Banking Department didn't seem like a big deal, in and of itself. "They failed to keep records. It doesn't seem like [they're] engaged in a fraud," says Raisler.
McKee says that he had conversations with managers of 10 funds of funds who had been approached by Bayou and who declined to invest in the hedge fund. Interestingly, each of them cited performance for the demurral -- not concerns about the fund's integrity.
Whatever the reason, investors in those funds weren't exposed to Bayou -- an example of how the search for diversity can sometimes be protection from a host of sins.
"The ultimate protection is to invest in a diversified fund of funds. With no position greater than 3%-4%, you can't lose more than that," says Richard Leibovitch, a Boston-based partner at $5.5 billion fund of funds Gottex Fund Management.
Rich people have long relied on word-of-mouth when picking asset managers. While the method remains the only game in town among the rarefied air of hedge-fund stars, it is quickly losing its luster as the industry mushrooms.
"For individual investors, it's who they know, what their friends are doing," says one fund of funds executive. "I think they're crazy."
