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Avoiding Hedge Fund Fraud

Managed accounts can provide transparency, at a cost.

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.

In many cases, financial risk and operational risk coexist. In the notorious fall of Long Term Capital Management, for instance, the default was not just due to bad bets but involved some degree of operational risk, says Giraud. (He argues that the collapse could have been avoided if the fund's mathematical models had taken into account government defaults as one of their variables, which they did not.)

So how can managed accounts help the investor?

First, they make fraud much less likely. When a manager does not own the account, he can't wire his investors' funds to himself. That takes care of the scenarios like last year's fall of Bayou Management.

Another protection concerns the pricing of illiquid or complex assets, such as private equity shares or derivatives. In a classic partnership, the manager is the only one defining the net value of these assets -- and that should be a concern for investors, Giraud says. Because such securities don't trade publicly, the temptation is great for managers to pump up their value, especially at the end of a bad month.

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Trading outside an operating mandate is another form of operational risk. What if a convertible arbitrage manager, for instance, begins to invest in corporate bonds without letting his investors know that they are now exposed to credit risk? That's a problem. In a managed account, all positions appear in the statement, and the investor knows exactly what he owns. He is immediately aware of any "style drift."

Despite all those advantages for investors, managed accounts have yet to revolutionize the world of hedge fund investing.

Out of a trillion-dollar hedge fund market, Giraud estimates that $150 billion, tops, is invested in managed accounts.

Managers are not necessarily fond of managed accounts. They are reluctant to give investors information on their positions for fear of giving away their trade secrets. One fear is that an investor, aware of the manager's daily positions, could open another, larger account elsewhere, replicating the strategy without paying a fee, says Giraud.

A related risk is that a bank that hosts a managed account could share trading information with its proprietary desk and compete with the manager or engage in front-running.

The potential for a sharing of information already exists due to hedge funds' use of prime brokers to handle their trades. But managers are careful to use several prime brokers and to only give them partial information. The industry average is 2.3 prime brokers per manager.

How can an adviser who is willing to run a managed account get around such pitfalls? One option is a managed account platform such as HFR Asset Management or Lyxor Asset Management. These platforms operate like funds of hedge funds, distributing money among different managers. But rather than collect the money in a partnership before investing it, these platforms gather money from the accounts of individual clients.

The advantage for the hedge fund manager is the access to a huge distribution channel. Lyxor, for instance, is a subsidiary of French bank Societe Generale, whose asset management arm runs $375 billion.

In other cases, a manager may agree to open a managed account with a pension, for instance, if the mandate is big enough. A half-billion dollars allocation will do for some. "If you are a small investor, you just do what a hedge fund asks you to do. But if you're large, you have more leeway to negotiate specific special conditions, and managed accounts are one of them," says Giraud.

Managed accounts also have a reputation for spotty quality when it comes to who ends up running the money. "Managed accounts are not necessarily the route to the best managers, because the best managers have no reason to take on those accounts and do not want to be bothered with the added paperwork," says Joe Feshbach, the Palo Alto, Calif.-based founder of Joe Feshbach Partners.

Another drawback, perhaps, is cost. Investing in a hedge fund through a managed account will cost the investor 0.2% to 1% more than a hedge fund's typical 1% to 2% management fee. For a large fund of funds that is already equipped to do the due diligence, paying the extra cost doesn't make sense. But it could for an investor who lacks the means to monitor managers and performance, says Giraud.