How Not To Fall A Victim Of A Hedge Fund by Arkady Bukh, Esq
Over the past decade, the US Securities and Exchange Commission (SEC) has led the way in high-profile enforcement actions against hedge funds. The SEC point to fraud in the hedge fund universe as a reason for expecting hedge fund managers to register. Just like other things in life, that is good — and bad — news.
According to the SEC, the news is that in recent years a number of actions claiming hedge fund scams have been instigated. The great news is there is no proof showing that hedge funds engage in fraudulent activity out of proportion for the total invested.
In view of the attention-grabbing hedge fund frauds, it is vital for investors to know how to keep from being victimized by the relatively few instances of hedge fund fraud.
Pros And Cons Of Tail Risk Funds
Editor’s note: This article is part of a series ValueWalk is doing on tail risk hedge funds. The series is based on over a month of research and discussions with over a dozen experts in the field. All the content will be first available to our premium subscribers and some will be released at a Read More
While the precise figure of hedge funds is hard to know because of an absence of centralized reporting requirements, it is obvious that hedge funds have developed, in number, exponentially, over the last decade.
Industry trade publications show that hedge funds have more than quadrupled in number from roughly 2,100 to over 9,000. Hedge funds currently account for up to 50% of everyday trading volume on the New York Stock Exchange.
How Investors Can Protect Themselves
Investors must conduct detailed due diligence before investing in any hedge fund. There aren’t any one-size fits all approach, though. Due diligence has to be tailored to the particular hedge funds being considered.
Regulatory agencies have identified nine indicators of hedge funds fraud:
- Lack of trading independence
- Investor complaints
- Audit issues
- Unusually strong performance claims
- Illiquid investments
- Valuation issues
- Personal trading
- Aggressive Bear shorting
Interview the fund manager, chief compliance officer, general counsel and chief operating officer as well as the portfolio managers and other key people.
Knowing how the financing is handled and how it fits is vital to grasping a better understanding of risk exposure.
Don’t hesitate to ask the tough questions. It’s your money and if you don’t understand the strategy, then you should ask more questions.
Too Good to be True
When speaking with the fund manager, reviewing the documents and examining the fund’s performance results, always ask, “Is this too good to be true?” If it is, then it may be a sign that the manager is potentially crooked.
Look, for example, at the Manhattan Investment Fund — MIF. MIF’s manager, Michael Berger, ran the $575 million hedge fund from 1996 until 1999. During that time, Berger assured investors he would make them money by shorting technology stocks based on his belief that it was dramatically overvalued. And he did.
The problem was he was doing so while there was an unprecedented boom in the market. While the tech sector was booming, Berger was telling investors he was making money by shorting the stocks. Berger’s plan didn’t make sense — it was too good to be true. Many high-quality investors threw money at Berger and invested hundreds of millions of dollars.
Berger continued to tell investors that the fund was making money by shorting the tech stock. Ultimately, many investors lost all of their investments — only because they failed to conduct due diligence.
The ability to honestly analyze and fully understand the results of your research can’t be overstated. Too many investors have been burned by following a simple “checklist mentality,” where they asked many of the right questions but failed to drill down and completely understand the answers.
When conducting due diligence, the investor has many tools at their disposal. For example, thoroughly read the fund’s documents including the offering memorandum, LLC agreement or articles of association. Search for, and read, any additional judicial documents about the fund including the administration agreement and management agreement. Pick up and digest the marketing materials. Examine the fund’s performance results as well as review its financial statements.
At a minimum, due diligence should include:
- Reviewing Gov for prior regulative efforts
- Review state agencies websites
- Review federal district bankruptcy and appeals court records
Much of this will sound obvious, but many investors only read some of these documents. The difference between skimming the documents or thoroughly studying them may form an expectation gap such as when the investor assumes the administrator to value the portfolio.
One last consideration — consider hiring a private investigator to perform a background check on the key people within the fund management company.
You can’t know what you may learn.
Lodge a Complaint
If you believe you have been victimized by criminal activity in a hedge fund, a complaint can be filed with:
- Commodity Futures Trading Commission toll-free complaint line: 866-FON-CFTC
Arkady Bukh, Esq received his Juris Doctor degree and was admitted to the state bar of New York in 2003. He was subsequently admitted to the Federal bar for the Southern and Eastern districts of New York.
Attorney Bukh stays active in his community by performing pro bono services to needy constituents in New York. He is a distinguished member of many professional organizations in the legal community, including the Russian American Bar Association, the Serbian American Bar Association, the Brooklyn Criminal Bar Association, the National Italian-American Bar Association, and the National Association of Criminal Defense Attorneys.