Hedge Funds Still in the Dark

by Eric Janszen


March 9, 2006

This morning we're treated to yet another hedge fund blow-up story on the front page of the Wall Street Journal Troubles at Fund Snare Doctors, Football Players (Subscription Required). Kirk S. Wright and his firm, International Management Associates, appear to have lost the fund's 500 or so investors most if not all of the $115 million that they invested.

The failure of Wright's fund adds to a long and growing list of hedge fund meltdowns, large and small. Usually only the larger failures make the news, such as Bailey Coates Cromwell Fund ($1.3 billion), Marin Capital ($1.7 billion), Aman Capital (est. $1 billion), Tiger Funds ($6 billion), and Long-Term Capital Management ($1 billion). But according to Nina Mehta reporting for Financial Engineering News, failures are common and their causes are numerous:

"A March study by Capco, a financial-services consultancy and technology provider, offered some grist to those unsure how significant operational risk can be. The firm investigated 100 hedge fund failures over the last 20 years and found that half of them failed because of operational issues rather than lousy investment decisions. These include misrepresentations and inaccurate valuations, fraud, unauthorized trading, technology failures, bad data and so on. The evidence for change may be somewhat anecdotal, but a number of industry experts say they see increasing hedge fund attention to operational issues."

So who cares if a bunch of rich guys lose a lot of money on a few bad bets? Three major issues.

First, there are a lot of hedge funds with nearly $1 trillion under management. According to the SEC report Implications of the Growth of Hedge Funds, September 2003, "The hedge fund industry recently has experienced significant growth in both the number of hedge funds and in the amount of assets under management. Based on current estimates, 6,000 to 7,000 hedge funds operate in the United States managing approximately $600 to $650 billion in assets. In the next five to ten years, hedge fund assets are predicted to exceed $1 trillion."

Second, they are unregulated: "The Report notes that one of the staff's primary concerns is that the Commission lacks information about hedge fund advisers that are not registered under the Investment Advisers Act of 1940 (the 'Advisers Act') and the hedge funds that they manage. Although hedge fund investment advisers are subject to the antifraud provisions of the federal securities laws, they are not subject to any reporting or standardized disclosure requirements, nor are they subject to Commission examination. Consequently, the Commission has only indirect information about these entities and their trading practices, thereby hampering the Commission's ability to develop regulatory policy."

Third, these thousands of unregulated investment pools collectively pose a systemic risk to the banking system and financial markets. A paper titled Systemic Risk and Hedge Funds by Andrew W. Lo, et al, writing for the National Bureau of Economic Research March 2005, states:

"Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions---typically banks---that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise."

The hedge fund industry itself, of course, argues that hedge funds are misunderstood, that the systemic risk they pose to the financial and banking systems are overstated. A hedge fund industry Hedge Fund Association web site explains the various types of hedge funds and states in a side bar:

"The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or donít use derivatives at all, and many use no leverage."

That's comforting except that on the same day that we read about Wright's hedge fund failure, and more than two years after the SEC report, we're treated to the story SEC Rapped Over Failing To Pursue HF Fraud from the venerable Institutional Investor Daily:

"The Securities and Exchange Commission has found Michael Lauer in contempt of court for violating an asset freeze order, acting in bad faith by not participating in the discovering process involving his hedge fund Lancer Management Group. To outspoken New York Post columnist Christopher Bryon the latest action is an example of SEC ineptitude, as the agency spends its resources going after small fry while not pursuing what could have been an eye-opening enforcement case against Lancer's administrator, Citco Fund Services. Bryon says the SEC has been sitting on top of the Lancer case since the firm went belly-up in 2003, and two weeks ago, according to the Post, a court ordered the unsealing of some 40 pages of internal e-mail memos and the like from 2002.

"Pursuing a case against Citco, Bryon writes, would have sent 'an unmistakable message to the entire hedge fund industry that those who break the law will go to prison.' Instead, he says, all the SEC can expect to get at the present is an injunction barring Lauer from the industry and relatively small fines. Bryon blames 'revolving-door leadership at the top [the agency has its fourth chairman in five years of the Bush administration], staff defections in the middle ranks and bewilderment at every level' regarding what constitutes 'improper and illegal' hedge fund behavior."

Fair to say that little if any progress has been made to regulate hedge funds, to "limit misrepresentations and inaccurate valuations, fraud, unauthorized trading, technology failures, bad data, and so on." In spite of well documented problems, systemic exposure of the banking system and financial markets to the failure of certain hedge funds has grown, and appears to have done so for the same reason that the stock market bubble of the 1990s was allowed to grow to outrages proportions: no one wants to end the party, not the politicians who need the tax revenue from hedge fund capital gains and not likely the hedge fund industry itself. It's hard to imagine the industry imposing a rule on itself, say, to hold sufficient reserves to cover liquidity risks. Such measures reduce unapparent risks but at the cost of lowering investors' very apparent and much touted returns. Not only will fund management bonuses based on returns decline, lower returns will make hedge funds less enticing, thus attracting less money, thus making hedge funds smaller and carry fees paid as fixed salaries smaller. Why would any hedge fund want that?

In our next commentary, we'll discuss the poorly understood risks posed by the over-the-counter (OTC) derivatives market.

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