By Simon Kerr, Publisher of Hedge Fund Insight
The world is full trusims and half-truths as well as data and information. The hedge fund industry has a disproportionate share of all of these. And this graphic and it’s heading are a major contributor to the truism and half-truth columns:
“An alarmingly high proportion of hedge fund failures can be attributed to operational issues”
Who could not respond to the heading and pie charts except with alarm? The graphic and heading come from a study by Capco published in 2003. The Capco White Paper was titled “Understanding and Mitigating Operational Risk in Hedge Fund Investments”.
This study has had many references in conference presentations, commentaries, articles, speeches and other studies since. It is argued here that the study and the graphic have had a completely disproportionate impact on the investing world.
The rational decision-maker and analyst on coming across such scary headlines and data representation will always ask a couple of key questions: “Was the study conducted with statistical rigour?”, and “Has the study been reported on and used with due care to its purpose and methodology?”.
There are issues related to the first question, but an awful lot more related to the second.
The Capco study was a short overview looking at the 100 or so hedge fund failures that the firm had kept a record of over the 20 years to mid 2002. What had happened to Askin and Lipper was the kind of thing stored and researched. The dataset was not a publicly available hedge fund database. The study refers to a 6000 fund universe of hedge funds at the time, but it did not analyse that universe. So the implicit question that was asked in the study was, “What were the causes of headline hedge fund blow-ups?” not “Why do hedge fund management companies go out of business?”. The Paper lays out the limitations of the study, so the consequences of its publication cannot be laid at Capco’s door.
There are some issues in relation to the categorisation in the Paper of some factors as being operational in nature. Is marketing mis-representation an operational issue? Is style drift an operational issue? That is, even within a study confined to 100 hedge fund blow-ups the extent of “operational risk” may have been over-stated. But the wider consequences of the mis-use of the Paper do not arise from these categorisation issues.
Reporting on & Reference to the Paper
In March of 2003 the paper was reported on in the hedge fund trade press like this:
“due diligence should concentrate on back-office systems” ran the headline followed by the article starting
“Half of hedge fund failures are due to operational risk, rather than bad investment decisions, according to recent industry research.”
The mis-representative headline has had echoes down the decade since. A provider of fund administration services has on their website:
A widely-quoted study once estimated that more than 50 percent of hedge fund losses were due to operational issues (Capco 2003, re-quoted Edhec 2004). These are losses you can control. The investor’s business plan drives the choice of fund strategy, and individual integrity and performance drives the choice of fund manager. Similarly, early and regular due diligence into the quality of a fund’s operational structure can prevent or mitigate future headaches.
Research in this area should be as comprehensive as that conducted into strategy and manager selection. A strong operational structure, managed by an independent third party, can help mitigate operational risk and provide transparency about the manager adhering to the agreed investment principles.
Let us make it clear that more than 50% of hedge fund losses at no point and for no subset of funds have been due to operational issues. This is a myth of the hedge fund industry with as much truth as the existence of a unicorn.
However, it makes a good headline. It makes a good simple story, and it helps support the marketing messages of firms selling software and due diligence consultancy.
Due diligence of the operations of a hedge fund are important and should focus on some key areas: Pricing, asset verification and payment wire controls should each be examined. The relative importance of due diligence of the operations of a hedge fund can be over-stated.
The Real Reasons Why Hedge Funds Close
The hedge fund industry loses many more participants each year for non-dramatic reasons than blow-ups caused by fraud. The attrition rate, the proportion of hedge funds closing down, has increased over time from 1.9% of the universe in 2001 to a peak of 13.5% in 2008, and the run rate is around 8% in recent years.
Each year about 8% of the world’s 10,000 hedge funds shut down. The reasons the managers decide to close the funds are mundane rather than dramatic. Fraud is rare and so is catastrophic mal-administration. More typical is this kind of comment by Howard Wong of Hong Kong’s Doric Capital Corporation quoted on Reuters – “It was a tough decision to close down the Doric Fund given its long and respectable track record spanning over 10 years. Nevertheless, its less-than-splendid performance in recent years has prompted us to re-align our core competency with our goal and thus focus on the Doric Asia Pac Fund.”
When Boyer Allan, the London based hedge fund manager, closed last year a number of reasons emerged or were given. They included “the firm’s “strategy wasn’t right for the markets and it’s hard to retool the entire DNA,” “U.S. pensions don’t like long-bias funds anymore,” “Allan and Boyer has also lost interest in fund management, and “falling assets and performance were to blame.”
Here area list of reasons why hedge funds close which are nothing to do with fraud or operational failures.
- Not enough alpha
- An alpha stream unsupported by technical infrastructure or further human resource
- Lack of discipline in taking off positions
- The managers didn’t prepare for the unlikely
- Portfolios were run with no reference to risk information
- Managers expressed their risk management in the quotation “Owning good quality stocks is the ultimate downside protection”
- Managers didn’t stress test hedging positions
- The net exposure was not a control variable, but was the natural product of long exposure and short exposure, each of which was opportunistically bottom up
- Ineffective marketing
- Managers couldn’t articulate their own added value or reasons for their attractiveness versus competitors
- Internal marketers underpaid , and the role was seen as a soft job – staff employed were too junior to make an impact
- Managers emotionally over-committed to positions because of fundamental attractiveness
- The fund over-traded
- Fees generated from AUM were too low to sustain costs of business
- The major backer(s) redeemed capital
Investors in hedge funds should certainly carry out back office due diligence checks in the three key areas given above. But much more resource should be devoted to front (alpha sourcing) and middle office (risk management) concerns when considering investing in a hedge fund.
There a many reasons given here for the commercial failure of a hedge fund management company, and they cannot be classified as hedge fund blow-ups. Hedge funds do not fail because of operational issues. It is not a great headline, but most hedge funds go out of business because the portfolio managers are not good enough as investors or managers of businesses. As Deepak Gurnani, the Head of Hedge Funds at Investcorp has put it, “Hedge funds attract the best investment management talent, but not the best risk talent.”