Assessing the Operational Risk of Hedge Funds

Title:
Trust and Delegation

Authors:
Stephen J. Brown (New York University), William N. Goetzmann (Yale University), Bing Liang (University of Massachusetts at Amherst), and Christopher Schwarz (University of California at Irvine)

Publisher:
New York University, Working Paper No. FIN-09-016

Date Published: 
November 2009 

In the hedge fund industry — where wealthy individuals and institutional investors habitually park large sums of money with investment managers on the basis of little more than word-of-mouth referrals — dishonesty is remarkably prevalent, according to the authors of this paper. Indeed, they say, part of the reason Bernard Madoff’s huge Ponzi scheme remained viable for so long is that the murky world of hedge fund investments depends to a large degree on unquestioned trust among agents, clients, and firms, with little transparency or third-party access to operations and performance data.

To evaluate trustworthiness (or the lack of it) and investor risk, the authors analyzed a set of 444 reports provided by a due diligence firm that assesses the operational integrity of hedge funds, often by conducting on-site interviews with money managers and background checks of key fund employees. In these lengthy reports, the authors found some disturbing results. More than 40 percent of the hedge funds either misrepresented such vital information as assets under management, a history of regulatory or legal issues, and performance measures, or presented inconsistencies in their reports that blurred their activities. In one case, a manager overstated his fund’s assets by US$300 million. In fact, the authors say, even when hedge fund managers knew that the due diligence firm was hired to verify critical information, many chose to misstate material facts.

The study found that hedge funds with prior legal entanglements, a record of inaccurate performance reports, high staff turnover, or questionable pricing strategies were more likely to generate lower returns over time or to fail completely. The connection between questionable behavior and future performance may seem obvious. But the authors point out that investors are often solely interested in a hedge fund’s stated returns and overlook past problems, which are actually a far better predictor of how a fund will fare down the road. 

Bottom Line:
This study emphasizes the vital importance of performing operational due diligence before investing in hedge funds. Misrepresentation of performance data and regulatory issues is both common and highly correlated with fund failure.