Friday, July 25, 2008

Hedge Funds as an Investment, Pt. II

Fiduciaries investigating hedge funds as an investment should read the Press Release, dated April 15, 2008, issued by the United States Treasury entitled "PWG Private-Sector Committees Release Best Practices for Hedge Fund Participants" (HP-927).

It announced release of a report, which should become "required reading" for any fiduciary contemplating hedge fund investments: the "Report of the Investors' Committee to the President's Working Group on Financial Markets" (PDF format, 205 KB, 63 pages).

I asked in yesterday's posting
Hedge Funds as an Investment, Pt. I, "What should a fiduciary know about hedge funds?" This Report contains the answers.

The Press Release summarized the importance of the Report:

Two blue-ribbon private-sector committees established by the President's Working Group released separate yet complementary sets of best practices for hedge fund investors and asset managers today, in the most comprehensive public-private effort to increase accountability for participants in this industry. * * *
The Press Release (also available in PDF format here) noted the fast-paced, high-level, top-priority nature of the study that led to the Report's issuance:

The PWG tasked the committees, selected in September 2007 and comprised of well-respected asset managers and investors, with collaborating on industry issues and developing a set of best practices for their respective groups of stakeholders. Their work was based on the PWG's Principles and Guidelines Regarding Private Pools of Capital issued in February 2007, which sought to enhance investor protections and systemic risk safeguards. The best practices may be viewed at the committees' websites,

The PWG includes the heads of the U.S. Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The best practices for the asset managers call on hedge funds to adopt comprehensive best practices in all aspects of their business, including the critical areas of disclosure, valuation of assets, risk management, business operations, compliance and conflicts of interest. * * *

During that process, on September 17, 2007, a Pennsylvanian, Blaine F. Aikin (managing partner and chief knowledge officer of fi360, of Sewickley, PA), published an article in the "international newspaper of money management", Pensions & Investments, also posted online, entitled "Hedge funds present fiduciary hurdles"?

His excellent article began with a caution to fiduciaries regarding hedge funds:

While it might be true that no investment is inherently imprudent, some start with a presumption of guilt until proven innocent.

Hedge funds fit into this category because of the inherent hurdles they present to fulfilling a fiduciary’s duties to their client. * * *
He then proposed a five-part inquiry by any fiduciary who contemplated a hedge fund investment:

1. Are you permitted to hold this type of investment?

2. Do you believe financial markets are inefficient and that such inefficiencies are exploitable?

3. Can you adequately evaluate the positions held in the hedge fund investment and the associated risks of those positions?

4. Are the fees and expenses of hedge funds fair and reasonable?

5. What recourse do you have if something goes wrong?

After explaining the risks underlying, and reasons for, each inquiry, he offered this advice:

Only after you have considered these questions and conclusively proven that your fiduciary duties are being met can you feel comfortable in selecting hedge fund investments.

Fiduciaries operate in a special relationship of trust and legal and ethical responsibility for managing the money of others. When it comes to hedge fund investing, the obligations attendant to the fiduciary role point directly to the line of inquiry presented above.

In my view, the hurdles that must be cleared to justify making hedge fund investments are too high for most fiduciaries. Those that do decide to proceed down the hedge fund path should be prepared to demonstrate that they did so properly by having a compelling case for their conduct prepared in advance.

When, on April 15, 2008, U.S. Treasury Secretary Henry M. Paulson, Jr. made remarks upon the issuance of the Report, reproduced in a Press Release, entitled "Secretary Paulson Opening Remarks at Release of Best Practice Recommendations by PWG Private Sector Committees" (HP-926), he mirrored the need for accountability regarding private pooled investments, including hedge funds:
Last September, experienced industry professionals from some of the most respected institutions agreed to serve on two new committees to address market issues and develop "best practices" for private pools of capital – one from the perspective of investors and one from the perspective of asset managers.

The President's Working Group encouraged the committees to use the PWG principles and guidelines as the foundation for their best practices, and they have done so. As we said when announcing these committees --- we want the world's highest investor protection standards; we want to guard against systemic risk and keep the United States the most competitive financial marketplace in the world. * * *
The Press Release (HP-926) noted key components of the Report:

The best practices for investors include a Fiduciary's Guide and an Investor's Guide.

The Fiduciary's Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio.

The Investor's Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio. * * *

Both best practices documents recommend innovative and far-reaching practices that exceed existing industry standards. The recommendations complement each other by encouraging both types of market participants to hold the other more accountable.* * *
The Executive Summary of the Report, reproduced (along with the Report's "Table of Contents") by Asiaing online, noted its importance to private investors, institutional investors, and fiduciary investors:
Thousands of institutional and individual investors meet the legal requirements to invest in hedge funds, but it is not always appropriate for them to do so.

Prudent evaluation and management of hedge fund investments may require specific knowledge of a range of investment strategies, relevant risks, legal and regulatory constraints, taxation, accounting, valuation, liquidity, and reporting considerations.

Fiduciaries must take appropriate steps to determine whether an allocation of assets to hedge funds contributes to an institution’s investment objectives, and whether internal staff or agents of the institution have sufficient resources and expertise to effectively manage a hedge fund component of an investment portfolio. * * *
Are you an investor or a fiduciary who is considering a hedge fund investment, or do you advise one about such an investment? Then you must read the Report.

Update: 07/29/08:

On July 29, 2008,
The Wall Street Journal's "Wealth Report", noted in a posting entitled "Wealthy Investors Cling to Hedge Funds" that "[d]espite all the bad press about hedge-fund performance recently, a Bank of America survey found that hedge funds are still popular with the rich."
The survey, of 400 clients with $3 million or more in investible assets, found that more than half of those with hedge-fund investments were “satisfied” with the funds’ performance.

That compares with an approval rating of just 30% for traditional investments such as stocks and bonds. Other alternatives also fared better than stocks and bonds: a 41% approval rating for venture capital, 41% for real-estate, and 35% for private equity. * * *

So the poor performance of hedge funds beats the horrid performance of stocks. The survey also found that investors who had held hedge funds the longest were the most satisfied. Those who had been investing in hedge funds for 10 years or more were twice as likely as those with less experience to be “extremely satisfied” — probably because they had all those heady days of double-digit returns to factor in to their assessment.

The critical question is whether the rich will keep putting money into hedge funds. Funding for new funds is drying up: In the U.S. the number of new funds has dropped by half. It’s about the same in Europe. * * *
Update: 09/06/08:

NBC News
broadcast a Dateline NBC segment
by correspondent Dennis Murphy on Friday, September 5, 2008, at 10:00 p.m., entitled "Mystery of the missing millionaire."
A wealthy hedge fund manager whom the rich and powerful trusted with their fortunes suddenly disappears – and the money was gone too. Turns out, all along he'd been playing a dangerous game with very high stakes. Dennis Murphy reports.
The description of the investigative report explores "hedge funds" and their managers, and reinforces some of the concerns expressed in recent years:
This giddy era, before the market’s recent swan dive, was dubbed “the new gilded age” and some of the young men becoming as rich as any Rockefeller or Andrew Carnegie of days past were masters of something known on Wall Street as a "hedge fund."

Top hedge fund managers have been reported to make anywhere from $100 million to a billion dollars a year. They do it by making already wealthy people and institutions even richer.

Someone who wanted in on the hedge fund action in the worst way was Samuel Israel III. He was a Wall Street guy who’d worked his way up here and there in the ‘80s and ‘90s as a trader. * * *

A hedge fund, like the one Sam Israel was starting up, is like a private club for wealthy investors. It usually takes a million dollars to get in the door.

And the very best hedge fund managers are a high priesthood of brilliant traders. They place complex bets that can pay off handsomely, even when others are losing their shirts. * * *

The website for the recent broadcast segment referenced a previous helpful MSNBC commentary, "What is the deal with hedge funds?" (08/27/07), by John W. Schoen, Senior Producer.