We always enjoy Matthew Lynn's columns on Bloomberg, and his latest is entitled "Hedge Funds Come Unstuck on Truth-Twisting, Lies" (Link). Ouch - not a pretty title.
In this article, Lynn touches on two academic studies. The first is by Veronika Krepely Pool, assistant professor of finance at Indiana University in Bloomington, Indiana, and Nicolas Bollen, associate professor of finance at Vanderbilt University in Nashville, Tennessee.
According to Lynn, the researchers "examined how hedge funds reported to their investors over several years. Although the funds often scored a gain of 1 percent a month, they rarely reported a loss of the same amount.
``We estimate that approximately 10 percent of returns in the database we use are distorted,'' they concluded. ``This suggests that misreporting returns is a widespread phenomenon.' "
We commented on this paper when it first came out. The issue is that hedge funds seem to suspiciously report more small "up" months than small "down" months, suggesting that some intervention may be at play to improve a fund's ratio of "winning" to "losing" months. This is, of course, a key metric in many fund marketing presentations.
In the second part of his article, Lynn states:
"A report from Wharton School of the University of Pennsylvania suggests dishonesty on a greater scale. Statistics Professor Dean Foster and Brookings Institution Senior Fellow H. Peyton Young said it is easy for hedge funds to start up and make money without having any real investment skills.
``It is very hard to set up an incentive structure that rewards skilled hedge-fund managers without at the same time rewarding unskilled managers and outright con artists,'' they said in a paper called ``The Hedge Fund Game.''
So how is it done? They say you can just replicate an investment strategy devised elsewhere, take big positions, and collect enormous performance fees until the whole thing blows up. By then, you will already have pocketed plenty of money, and you won't have to pay any of it back if the fund goes bust.
``It is extremely difficult to detect, from a fund's track record, whether a manager is actually able to deliver excess returns, is merely lucky, or is an outright con artist,'' they said."
The FT recently reported on the same points - see our comments here.
It's a truth in pretty much any area of the economy that no-one likes to ask tough questions when everyone's making money. Today, obviously, is the time to ask these questions. In our view, the current period of market turbulence provides a necessary - and probably overdue - opportunity to rethink some of the "sacred cows" of the hedge fund industry.
In our recent posts we've touched on some of these items, notably the need to focus on hedge fund fee structures. We see a pressing need to debate whether 2 and 20 really aligns investor and manager interests, or whether it's actually a mechanism to allow a fortunate few to become billionaires as quickly as possible. Indeed, one of the ironies of the "institutionalization" of today's hedge fund industry is a stupendous wealth transfer from the millions of individuals who are the beneficiaries of institutional pension plans to a tiny number of hedge fund managers. Interesting times indeed.
Aside from the question of fees, the recent news that numerous funds have put in place gates and created new side pockets also raises many, thorny issues. This will be the subject of our next post.
The Bank of New York announced yesterday that their administration business has reached the milestone of some $200 billion in assets under administration (see article from Hedgeweek).
One metric for competition between the administration companies has clearly become AUA (assets under administration), with the natural assumption that bigger is better. In our view, however, investors need better, more comparable information - $100 billion from one firm may not be the same as $100 billion from another.
We see two particular issues:
Firstly, how much of the admin's AUA is fund of funds versus single strategy hedge funds? It's clearly much easier to complete administration on fund of fund products than active, underlying hedge funds. In our view, admins should separate out how much of their business comes from each source - it is fundamentally misleading to combine two entirely different service offerings.
Secondly, how much of the AUA represents full service administration compared to NAV Light or share registration only? As we've pointed out before, not all fund administration is created equal. Being hired by a $20 billion multi strategy fund just to handle the shareholder statements is obviously not the same as being hired by that firm to maintain transaction accounting records, value the portfolio, and cut the NAV. Yet, the $20 billion share registration client still inflates the AUA figure.
We're reminded of the case of a small Bermuda admin shop that merely provided directorship services to a large, well known hedge fund group, but still included those assets in its assets under administration figure. Several other admin companies have large reported AUA but, for the vast majority of their clients, provide only share registration servicing or, at best, limited forms of "NAV Light".
This second issue is much more challenging, because it highlights the fact that there is no such thing as "standard" administration servicing. Going forward, this is going to be an ever greater due diligence challenge - we are seeing less rather than more standardization, and particularly much less admin involvement in pricing (which will be a topic to which we will return).
Finally, we couldn't let the BoNY press release pass by without highlighting the phrase:
'As the trend continues, hedge fund managers will need to be able to provide institutional-quality services supported by an independent third-party provider. The Bank of New York Mellon offers the stability and custom reporting these clients demand."
Guys - your client is the investor, not the fund manager. We're the ones that pay your fees - remember?
During a recent conversation, someone mentioned "Paulson". It struck us that the association the hedge fund industry has for this name provides just one little example of how things have changed over the past 12 months.
A year ago, mentioning Paulson immediately brought to mind the hedge fund firm and its uber-successful sub prime trade.
Today, Paulson means Hank Paulson, suggesting Fed / government intervention to save us from financial failure (perhaps).