Incompetence … and Incompetence Again

  • DATE 16/02/2009

The unique hedge fund risk assessment problems arising from numerous causes like non-normality of their distributions of returns, bizarre hedge fund indices and data biases are not new. One may easily find hundreds of articles and deep researches on the subject as well as a few proven investment frameworks offering feasible solutions by enhancing the commonly used risk metrics.

While these frameworks may vary in the suggested models and their implementation, they all have one thing in common: the mean-variance risk valuation methodology is hardly applicable to single hedge funds and, to an even greater extent, to hedge fund of funds.

Still, it does not seem these voices are being heard by the financial institutions. According to our own due diligence on hundreds of investment managers, over 85% of the total number of one hundred and fifty six recipients still widely use the classic mean/standard deviation metrics for hedge fund risk assessment combined with the “proven” Tactical Asset Allocation as the way of constructing hedge fund portfolios.
Surprisingly, no one has ever been really arguing the obvious facts of inapplicability of traditional risk frameworks. You may ask then, why not to use something more advanced and appropriate for alternative investments? Well, among many given excuses, there are a few most typical and funny ones:
  • “our senior management will not understand this”;
  • “it would take years to approve a new framework”;
  • “we are not sure, if we need it at all… we are investing into real estate funds” - that wise statement was made, obviously, before collapsing the US real estate market;
  • “we do not need a new quantitative framework; our investment process relies on the I-know-my-managers routine; so, we know what to expect from them.”

What is really needed for these people to learn something? A new LTCM? A new Enron? A global meltdown? Almost every month another institutional fund collapses. It has become a common habit to blame the subprime crisis for everything, for all the losses and defaults.

Though we cannot deny the negative role of the credit crisis and its global domino effect on the HFoF performance, the most important factor nailing the HFoF industry down is wild incompetence. Thus, managing a single hedge fund requires a high degree of professional expertise and, without doubts, a hands-on experience in trading, derivatives, hedging models etc. In contrast, managing a fund of investment funds is often viewed as a simple task that requires no expertise whatsoever. Just look at the real-world examples (the real names are not mentioned due to the obvious reasons):

  • A hundred million dollar fund of funds had been effectively managing by a former police officer (over 15 years in the forces) having only a few months accounting courses as a financial degree substitution;
  • A senior fund analyst holding a Bachelor of Arts degree in music;
  • A hedge fund of funds portfolio manager, who is a full-time professional hockey player;
  • A managing director and a Chief Investment Officer of a two-billion dollar fund having a Law Degree with the majors in the civil law and philology.

We could list plenty of similar examples clearly demonstrating the same devastating trend: professional skills do not seem to be mandatory in the HFoF industry. No wonder, all funds proudly managed by the mentioned people successfully collapsed in 2007-2008. Guess what happened to all these “investment experts”. Nothing bad at all. Most of them successfully moved up to other top-grade financial institutions occupying high-status positions.

One may say these examples are extreme and unrealistic cases that should not be taken seriously. Well, if the assets of two-billion dollars under management are not a serious case, take a look at the senior portfolio manager's job requirements posted by an Australian institutional investor with over $60 billion AUM:

Relevant Experience Required: 1-5 years experience working as a professional in fields such as finance, portfolio management, accounting, law or engineering.

So, anyone with, at least, one-year experience in whatever fields would qualify for this job, i.e. manage a hedge fund portfolio of about 2% of total assets, which translates to $1.2 billion portfolio.

What is the conclusion of the whole story? Everyone can make their own conclusion, which fully depends on which side of the table one belongs to. Our own position should be clear enough.


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