Avoiding Mistakes in Hedge Funds: Lessons Learned From Blowups & Frauds ~ market folly

Monday, February 18, 2013

Avoiding Mistakes in Hedge Funds: Lessons Learned From Blowups & Frauds

Greenwich Roundtable has published an interesting piece on Best Practices in Alternative Investing: Avoiding Mistakes.  In it, they dive into due diligence on fund manager selection in an effort to examine warning signs of potential trouble in funds.

They utilize case studies to showcase hedge funds that have failed and how investors could have identified these warning signs and minimized the impact. 

We thought this would be an excellent study for two groups of people: those invested in (or looking to invest in) hedge funds, as well as potential hedge fund managers looking to launch a fund.  Everyone can learn from others' mistakes here.

Warning Signs Learned From Hedge Fund Blowups

While there are numerous reasons for hedge fund blowups, two reasons at the forefront seemingly always are excessive leverage and liquidity (or lack thereof).

The document goes in-depth with various case studies, but for summary's sake, here are some of the warning signs they've highlighted:

- Fund was managed by one person with no risk manager

- Dangerous extent of portfolio concentration could have been revealed through conversations

- It's vital to conduct reference checks on key people

- Lack of clear measures of leverage or liquidity in monthly reports

- Manager had track record of less than one year

- Strategy drift

- Lack of transparency

- Assumption that a former analyst can all of a sudden perform as a portfolio manager at a new fund

- Lack of a key man clause

- Beware of a hard sell, especially with third-party marketers

- Manager full of hubris

- Fund grew assets way too quickly

- Fund grew but operating staff didn't grow to keep up

- Abrupt personnel changes/resignations

The end of the report essentially breaks down the categories where warning signs appear: risk management, illiquidity, transparency, complexity, operations, strategy drift, rapid growth, and hubris.

While there are many potential 'yellow flags' in blowups, the two glaring red flags always seem to be excessive leverage and/or illiquidity.

Embedded below is Greenwich Roundtable's comprehensive document on Best Practices in Alternative Investing: Avoiding Mistakes:

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