Did the Stock Market Collapse Help Some Hedge Funds Mask More Serious Problems?

November 9th, 2009
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Contributed by: RiskCenter
by Shahin Shojai, Global Head of Strategic Research, Capco -- The past couple of years have not been very kind to hedge funds. While there is never any really accurate data about the number of hedge fund failures in a given year it does seem that quite a few have had a tough time of it lately. Many investors have withdrawn their capital from hedge funds and as a result many have collapsed. The commercial rental prices in London’s Mayfair area is probably the best gauge, and it has collapse. However, if one was to believe that many hedge funds are managing well-balanced, and even market neutral, funds they should have withstood the market collapse much better than their traditional counterparts. More importantly, the lessons of the collapse of 2000 should have prepared them for such an outcome and most would/should have been better prepared. Yet, a good number collapsed, and the blame was placed with the investors who were unable to withstand the volatilities of the market at a time when they most needed to control their nerves.

The fact that a large number of investors withdrew their money is not debatable. Many did, for a myriad of reasons. However, something tells me that this was the best thing that could have happened to a number of hedge funds who had been experiencing losses for some time and were too afraid to tell their clients, and even worse were simply using their clients’ monies for personal reasons. I am in no way suggesting that most hedge fund managers are like Bernard Madoff, but do suspect that a small number do have a good time at their clients’ expense.

It is astonishing that in today’s world, there are investment vehicles, with the magnitude of money we are talking about, that can pretty much do as they wish with clients’ monies and use safeguarding of investment methodology as an excuse not to unveil just how they are spending/investing client funds. That would be a valid argument if only they did really perform as well as many thought they did/would. To fare even worse than their traditional counterparts, who are heavily hampered in how they can invest thanks to the investment consultants who set very strict limits on their investments styles, during a market crash does not exude confidence.

Few can deny that some people withdrew their funds from hedge funds because they were afraid that their own funds were smaller versions of one of Bernard Madoff’s investment vehicles. Fear of finding out that a life’s saving had been spent on someone else’s luxurious lifestyle forced many to withdraw their capital.

Consequently, if some had in fact wasted client money on themselves, the market crash was a gift from god. The crash allowed them to blame all the capital spent on the market correction and get away Scott Free. Now, of course, there are many honest and honorable people who manage hedge funds around the world, but the mere fact that someone is allowed to hide how they are spending clients’ money, irrespective of whether they think they are professional investors or not, is beyond belief. It would be like having a casino that is not regularly checked to see if it manipulates the machines to be biased against the punters. And, yet allowing hedge funds to hide what they do with clients’ assets is doing just that.

The big question is not why hedge funds would want to hide what they are doing with other people’s money, but why do people allow them to do that. This desire to not fall behind their peers/friends has made many people hand over their hard earned cash to people they have never met before, whose ability to make money without the might of their former employers behind them, and that is assuming they used to run proprietary trading desks, has not been tested, and whose integrity has never been examined.

The mere fact that very few are actually able to give investors risk-, and fee-, adjusted returns that are superior to mere market indices proves that there is really no reason to allow them to hide what they are doing with other people’s monies. Somehow, it seems that it is this veil of secrecy that attracts people to hedge funds. In fact, from my perspective, the secrecy itself is a risk that needs to be incorporated into the overall risk models used to examine hedge fund performance. When that risk is also incorporated into the numerator of the models used, if it could be, most will find that hedge funds are in fact generating total risk- and fee-adjusted returns that are significantly inferior to their traditional counterparts.

I think that this crash has provided us with a great opportunity to start asking whether it still makes sense to have a dark corner in the world of finance when even in the light areas people can take risks that pushed us to the brink of meltdown and will certainly do so again in the not so distant a future. In my opinion, hedge funds should not only be regulated, their management should also be credit checked.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).
For Detailed Investor Profiles on these Investors, click below:
Madoff Investments LLC
Related People: Bernard Madoff
Related Article Tags: Hedge Fund Fraud and Ponzi Scheme News; Hedge Fund Resources and Featured Partner News

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