A recent SEC complaint alleges that a hedge fund manager called Robert Stinson (helpfully described as a "convicted felon and securities fraud recidivist") raised some $16 million from investors from 2006 until he was caught earlier this year. Needless to say, instead of investing that capital in a genuine hedge fund strategy, the SEC claims that Mr. Stinson used the cash "to fund lavish spending involving restaurants, yachts, automobiles, baseball games and travel."
The first red flag - Mr. Stinson had named his hedge fund company "Life's Good." We would rest our case at that point, but apparently not everyone has our aversion to blatantly ridiculous management company names.
Also of interest, the Life's Good STABL Mortgage Fund LLC was, according to a news article, rated by Morningstar, where, surprise surprise, it received the maximum 5 star rating. When the returns are entirely fake, it stands to reason that it is relatively easy to produce a 5 star track record.
In fairness to Morningstar, their rating product is crystal clear with the caveat emptor disclosures that it (i) relies entirely on manager reported data (which could, therefore, be fraudulent) and (ii) that Morningstar has developed four "operational red flag" criteria, with the Life's Good fund, per the news article, violating three of the four during its tenure in the database as a 5 star performer.
A Morningstar paper outlining the four red flag criteria is available here - the four are
(i) recognized auditor (where an auditor acts for at least 5 other funds in the Morningstar database)
(ii) recognized administrator
(iv) returns do not evidence serial correlation
We're not sure which of the four operational red flags the STABL fund violated, but the most interesting is probably the latter - returns which do not evidence serial correlation.
Our comment here is not to criticize Morningstar, who appear to have been pretty clear as to the quality, scope and limitations of the information they were selling. Rather it is the broader point that focusing on investment returns alone can be entirely unhelpful unless operational analysis is also included. ODD can kick the tires for blatant fraud, and, more subtly, can comment on the quality of reported returns by analyzing the quality of a fund's pricing process.
Let's take the examples of two multi billion distressed debt funds. In one fund, the back office gathers a collection of broker quotes direct from the underlying brokers, removes any outliers, and takes the mathematical average of the remaining bids to determine the price used in the fund's NAV. In the second case, the front office marks the portfolio, and the back office will accept the price as long as the front office mark falls anywhere within the range of the lowest bid to the highest ask from the quotes received. Which one will have the highest measure of serial correlation...but also the highest Sharpe ratio?
In this case, operational due diligence information is critical to help investors make a more informed choice between these two, hypothetical funds. In the real world example of Life's Good, Morningstar's research clearly illustrates the worst case outcome when a fund has a 5 star track record, but a 75% red flag rating.
Hedge Fund Operational Risk Due Diligence
"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc. All rights reserved.