"I'm a rogue," Raj Rajaratnam, founder of the Galleon Group, memorably declared. He may have come to regret those words, caught on federal wiretaps and made public during Rajaratnam's recent insider trading trial, leading to his conviction.
While Rajaratnam may have been honest with himself about his lack of ethics, relatively few investors were aware of it. Instead, they were dazzled by his hedge fund's success in gaining an information edge, and turning that edge into megaprofits for both Galleon's leaders and its investors.
The problem? That edge was obtained by bribing or coercing Galleon employees and a network of outsiders into providing Rajaratnam with insider information on a host of companies, including such names as Advanced Micro Devices and Polycom. Especially desired was advance warning of outsize earnings. That information was the basis of much of the profits Rajaratnam and Galleon returned to investors.
"I remember sitting across the table from Raj at an introductory meeting organized by Goldman Sachs and wondering, how on earth does someone get it right so consistently, across a number of industries?" says Carter Furr, managing director of alternative investment strategies at Signature Financial Management in Norfolk, Va. "Very early on in the meeting, it was clear this was a non-starter for us, because we were cynical about these hyperactive trading strategies," he recalls. And yet, scores of other investors either ignored or never had such concerns; at its peak, Galleon had $7 billion in assets under management.
For financial advisors and their clients, the allure of hedge fund investing is unmistakable. At their best, these private pools of capital have extraordinary freedom to find gains.
In theory, a multi-strategy hedge fund could put startup capital into a Macao casino, develop a complex derivatives strategy based on European debt and place long-term bets on new tech companies - simultaneously. They face few restrictions, and are able to short securities or use leverage in hopes of maximizing returns.
Best of all, they offer advisors a way to diversify their portfolios beyond the stocks and bonds open to all investors. True, most hedge funds didn't generate positive returns in the firestorm of 2008, but they did again demonstrate that they weren't completely correlated.
On average, they provided more of a cushion: a study by finance expert Roger Ibbotson published early this year showed that hedge funds generated an average alpha of 3% annually from 1995 to 2009. No wonder investors are pushing their advisors to get them into hedge funds, and advisors are urging their clients to consider hedge funds as a way to diversify and boost returns.
A problem, Furr says, is that it's hard for most advisors to undertake the level of due diligence required to figure out which hedge fund managers can genuinely add alpha, and which ones are breaking the law (like Galleon) or perhaps orchestrating a massive fraud (Ã la Bernie Madoff). "There's a lack of transparency in this industry, and the alignment of incentives can lead to bad behavior on the part of bad actors," he says. "I believe there are more [hedge] funds in existence than there should be, and that those that genuinely earn their fees consistently are a very small subset of the industry."
An entire industry has sprung up around the need to do due diligence on hedge fund managers and their strategies. Some of its members spend their time probing the background of managers, looking for any signs that they are willing to take excessive or unwarranted risks, or if any of their past history or anyone in their network of colleagues raises a red flag.
"We'd look at whether they are into racing cars, extreme sports or piloting experimental aircraft - and how much time they spend doing that instead of running the fund," says Tim Mohr, head of the hedge fund investigative due diligence practice at BDO Consulting in New York. An especially ugly divorce can eat into a manager's ability to concentrate on what's happening in the financial markets.
Yet another issue: "I'll look for people who might be related to each other in key positions within the fund and its advisors, like its auditor," Mohr explains.
Mohr doesn't scrutinize hedge funds' methodologies. That's the task of people like Neil Chelo, director of research at Benchmark Plus, a Tacoma, Wash.-based fund of hedge funds group.
Chelo helped whistleblower Harry Markopolos probe the Madoff fraud, and now spends his time ensuring that Benchmark investors don't end up in any other troubled or fraud-ridden funds. He also seeks out funds that genuinely add value.
"I'm actually a really strong believer in the efficient market hypothesis," he explains. "What we try to do here is to see what inefficiencies a manager is trying to capture, or whether that manager really has an advantage that can add value."
That's pretty tricky in the large-cap stock universe, he says, pointing out that it's hard to get a real information edge on the likes of Exxon Mobil, a giant corporation with a market capitalization of some $400 billion. "I probably have the same access as anyone else does to what's happening there; it's hard to believe someone who claims to have better information if they are getting that legally."
In contrast, those who do due diligence point out that activist hedge funds, like Bill Ackman's Pershing Square Capital Management, can actually effect change at the companies in which he invests. In situations like these, a hedge fund can create new kinds of information.
DUE DILIGENCE DILEMMA
Events of the last few years, from the stock market crash to the Madoff scheme and the Galleon insider trading case, have reinforced the importance of due diligence. "Anyone who is going to invest in [hedge funds] needs to grasp what a manager does to earn alpha, what they do to generate returns and what risks they take in pursuit of excess returns," says Simon Fludgate, a partner at Aksia in New York, which analyzes hedge funds for institutional investors.
For most financial advisors, that is neither simple nor straightforward. Hiring specialized consultants to do hedge fund due diligence is costly, and unless an advisor is lucky enough to have vast sums of assets under management, they won't be able to hire someone like Signature's Furr to do the research.
Nor, if they only have a few million dollars of client assets to invest, is an advisor likely to get face time with managers or staff at those funds. Even veterans admit all problems cannot be readily identified.
"I don't know how it would be possible to be 100% confident that a fund has no exposure to insider trading. No matter how much time I spent with a long-short manager, I'd never [know] because there are no obvious, simple questions to ask and because the law is gray," says David Romhilt, who heads due diligence at Barclays Wealth, the division of the banking giant that advises affluent investors.
Nonetheless, many advisors want to add hedge funds to client portfolios. What's the solution?
One option, of course, is to invest in fund of hedge fund vehicles and let their staff handle the due diligence. That makes the investment process a bit easier, as well; when a single advisor's assets are pooled, it becomes a significant enough chunk of cash to convince hedge funds to open up and answer due diligence questions.
But a fund of funds comes with more fees atop the traditional 2% management fee and 20% of the performance that a hedge fund manager charges. And it raises new questions: How good is the fund of fund's due diligence process?
WHAT TO ASK
Veterans of hedge fund due diligence agree that while individual advisors are at a disadvantage when it comes to trying to figure out which hedge funds follow best practices, there are a handful of key questions a planner can ask that will boost the odds that they end up in an above-average fund, while avoiding the Galleons of the future.
* What strategy details will they disclose? "The Galleon model was one where they were trying to trade on short-term information," Romhilt says. "That's a strategy we tend to avoid because it's hard to verify that someone really has better networks and information over those short periods of time."
In contrast, when seeking out hedge funds for Barclays' affluent client base, Romhilt looks for funds with a long-term focus, and not just because these happen to be more tax efficient for investors. "One of the great arbitrage opportunities is between short-term and long-term gains," he says. "If a manager buys in the belief that a stock is going to $25, it doesn't matter as much that the entry point is $7 or $8," he explains. A fast-trading philosophy is a worry for Furr as well. "How many managers can constantly get short-term moves correct? Does that make sense?" he asks skeptically.
* Are they too big to succeed? "Asset growth is an impediment to future returns," Romhilt says. The phenomenon is familiar to advisors from the mutual fund world, where behemoths like Fidelity Magellan saw their returns slip from astonishing to merely adequate as asset size ballooned.
Furr says his firm gravitates to funds with less than $1 billion in assets for that reason. That is particularly important in some strategies where the ability of a market to absorb new capital hasn't yet recovered from the financial crisis, meaning a flood of new dollars is likely to distort valuations.
* What is its specialty? Romhilt and his team keep their eyes open for hedge funds that tend to do one or two things - and do them well. "Those managers aren't in it because it's the hot asset class today, but because it's a market they know well. They understand the cycles and how to navigate," he says. That may mean looking for boutique funds or funds that are small but established players in out-of-favor sectors.
However, a strategy that has a limited capacity but is attracting a lot of assets can mean a fund and its managers are thinking less about long-term returns than about maximizing management fees. If an advisor gets the opportunity to talk to the managers during due diligence, ask questions that will signal how alert they are to issues of size and capacity. "You want to avoid the folks who are just in it for the 2 and 20 in fees," Furr notes.
Any fuzziness is a sign that they may not understand their own process. "At one large hedge fund, I asked about their largest short position, and within a few minutes, we realized that these guys hadn't put much work into it - they couldn't produce a model, only two random emails about the decision," Chelo recalls. And can they explain why their strategy will pay off for them more than it will for dozens of rivals?
* How are the fees calculated? Digging into a hedge fund's fee structure will reveal more clues about the manager's priorities, Fludgate says. While the management fee and the "carry," or the manager's share of profits, are standard, hedge funds have different approaches when it comes to handling other expenses.
Sometimes, hedge funds will push audit and administration fees to investors, which Fludgate says shouldn't be much more than 20 basis points. Others ask investors to foot the bill for research fees, salaries and other costs that many funds will cover from the 2% management fee. "We really want to see an alignment of interests between the manager and the investor, and the way fees are structured is an important element in this," Fludgate explains.
* Are there signs of trouble? Are they forthright about who their counterparties are and how back-office operations are managed? Advisors should also run basic background checks, looking for regulatory run-ins by the managers or their staff. That, several due diligence pros agree, would have raised red flags about Galleon's activities. "It's all about minimizing missteps," Furr says.
Advisors who aren't confident of their ability to obtain answers to these questions - or who don't have the skill to analyze a fund's methodology and results - still have options. As hedge funds have grown in popularity, a convergence between the relatively illiquid and still opaque world of the "hedgies" and the much more transparent mutual fund universe has begun to take place.
Absolute Investment Advisors opened a public fund of funds in 2005, which now has some $3 billion under management; Simple Alternatives launched its own "40 Act" mutual fund/hedge fund hybrid late last year (named after the federal 1940 Investment Company Act) and has attracted about $30 million in assets.
That market may not be fully mature - those keeping an eye on it say top-tier hedge fund managers have yet to launch hybrid vehicles - but "that talent gap will close," Romhilt argues. Since the interest in launching hedge funds or the investor appetite for outsize profits appears unlikely to evaporate any time soon, he may be right.
Suzanne McGee is a freelance writer in New York and the author of Chasing Goldman Sachs.