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Four Questions that will allow you to do your Due Diligence over the Phone.
Last year Deloitte Financial Services published a report titled, Precautions that pay off: Risk Management and Valuation Practices in the Global Hedge Fund Industry.If we can believe what the report says, the hedge fund industry is doing pretty well; most of us are following industry best practices.For example, 86% of the hedge fund companies surveyed have position limits.This should not only give investors comfort, it suggests that due diligence need be little more than a phone call and a check list.Any firm that does not have position limits, for example, can be written off as amateurs, wannabes, losers.As a matter of fact, there are questions that you can ask over the phone that will let you avoid losers, not all losers, but some. Q1: Do you have position limits? A firm that doesn’t have position limits and portfolio limits does not have risk control.Any firm that will admit that they don’t have position limits, therefore, can be safely written off. Q2: Can you send me a copy of your risk management policy statement? Unfortunately, the fact that hedge fund managers say they have position limits doesn’t mean they actually have them.Information on position limits, if they exist, should be included in a hedge fund’s risk management policy.According to Deloitte, only 80% of hedge funds had a written risk management policy and only 60% shared the policy with investors.Hedge funds that do not have or are not willing to share their policy with investors can be written off—unless they are willing to change their policy while you are on the phone.I can imagine a hedge fund making a break-through in risk management theory or practice and wishing to keep it secret.For example, Mohamed El-Erain, former president of Harvard Management Co., which managed the $29.2 billion Harvard University endowment, wrote in the July 26, 2007Financial Times: “(We are) entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.”Assume this is true or, at least, assume that a hedge fund manager believes this is true, I still see no reason why this would prevent him from publishing part of his policy.For example, the public part of the policy could state, “We will never commit more than 10% of our money to any single investment.However, we reserve the right to invest less than 10% if we deem the risks too large.The exact amount we commit is based on proprietary risk management algorithms.” Q3: Who enforces risk management policy? A risk management policy that is not enforced is, at best, good intentions.Someone needs to do the job and that person cannot be the portfolio manager.There are two issues here.First, some smaller firms may not be able or willing to pay someone to watch their positions full time.Tough.They still need someone to do the work.Second, firms with fully automated trading systems will argue that they don’t need anyone to watch their positions; their software does it.There is much merit to that argument, of course.Unfortunately, for such firms, unless they can somehow prove that their software is bullet proof, there is no reason for investors to trust them; excuse me, there is no reason for investors to trust their software.There is no bullet proof software.The best such a firm can do is point to someone else, someone other than the portfolio manager and his employees who has reviewed the software.Or they could argue that the software has been in use for a long time and they now trust it.A fully automated system gets partial credit here, at best.
Q4: If the person who enforces risk management policy fails, what is their legal liability?
The next problem here is making sure the person who enforces the risk management policy actually enforces it.According to the Wall Street Journal, Amaranth had a risk officer named Robert Jones, who received a bonus of, at least, $5 million for his work in 2005.Mr. Jones’s job must have been to set and enforce position limits.If not, what else could his job have been, other than that of a figurehead?Judging by what I have read in the press, Amaranth failed because a single trading idea went bad.This is not much different from saying that Amaranth failed because it blew one trade.My guess is that Mr. Jones really tried to do his job and was overridden by Brian Hunter, Amaranth’s star energy trader.This is, unfortunately, entirely typical of our industry.Unless the risk manager is independent of the portfolio manager or, better, legally liable if he does not follow the hedge fund’s risk policy, he is just another figurehead or, at best, just a guy with good intentions.
The four questions above should allow you to eliminate something like fifty percent of the hedge fund managers asking for your money.Could the people you eliminated have made you money?Sure.Amaranth made money for their investors for years, but would you have put your money with them knowing what you know now?
Are there other questions you need to ask?Well, sure, you will notice that I didn’t say what the risk management statement had to say, which is of some minor importance.The questions above would allow you to check off a firm with position limits of 99% of their available capital, which is a prescription for suicide.You really do have to read the risk management policy statements and think through the issues.You really do need to make site visits.Fortunately, some managers can be written off rapidly; you don’t need to visit everyone.
A Note from One of my Readers. Enjoyed your articles and views, especially on risk, DD and the possibility that some managers lie. One question worth asking during the risk process is to review minutes of the manager's risk committee meetings. You'd be amazed (or maybe not) that many managers who have written risk policies, and claim to have robust risk processes, cannot back that up with minutes of past meetings, or firm examples of what has actually occurred when a risk limit is approached, met or breached.
Keep up the good work.
Chris www.fundmonitors.com Hi Chris,Thank you for your kind remarks. You are absolutely on target. I've seen the same problem. Technically, it doesn't matter why they don't enforce their risk policy, but I must admit I can't see that kind of behavior and not wonder why. Thank you for writing. --Fred
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"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.