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Jun. 25, 2009
Exclusive Interview: Hedge Fund Expert Richard Bookstaber

"Don't Trust The Numbers Coming Out Of Any Hedge Fund"

Rick

Richard Bookstaber, renown risk management and hedge fund expert, is the author of the book “A Demon of Our Own Design”. He is also the author of three other books and scores of articles on finance topics. Richard Bookstaber worked at Bridgewater Associates, ran the Quantitative Equity Fund at FrontPoint Partners and was in charge of risk management at Moore Capital Management. In the investment banking arena, he served as the managing director in charge of firm-wide risk management at Salomon Brothers and was a member of Salomon's powerful Risk Management Committee. He received numerous awards for his research and holds a PhD from MIT.

In the following exclusive interview with MyPrivateBanking.com Richard explains his views about risk and hedge funds with a special emphasis on the private investor.

MyPrivateBanking.com: Are there important alarm signals regarding hedge funds when the private investor should wake up and call his bank immediately?

Richard Bookstaber: Unfortunately, given the limited information that most funds currently provide, any alarm signals loud enough for the private investor will not come until it is too late. It doesn’t help to make a call after the fund announces that it is down twenty percent. By the way, to make it clear, I am speaking here specifically of market risk-related issues, questions related to taking on improper or extreme risk, or growing too large for a particular market. I am not an expert in the issues related to fraud and outright deception.

MyPrivateBanking.com: How do you view the role of (private) banks and wealth managers as middlemen between investor and hedge funds?

Richard Bookstaber: In theory or in practice? In theory, they should provide oversight and expertise, bring the tough questions to the hedge fund manager, and be the recipients of vital information. And if they can’t get that level of information, they should admit they will be unable to do their job and look elsewhere. In practice, well, we’ve seen what happened with Madoff. Granted that was a small subset of the profession, and there no doubt are many other managers who walked the other way when given the opportunity to invest with him.

MyPrivateBanking.com: Some of the bigger private banks run their own fund of hedge funds. Do you think they provide more protection to the private investor than single hedge funds?

Richard Bookstaber: Again, in theory I can make an argument on why they should. The bank has deep pockets and a broad reputation to defend, so it should be more cautious in making the hedge funds under its purview not do anything that either damages its reputation or leads to a liability. The problem is that the banks often are so large and encumbered as organizations that they cannot provide the level of oversight one might consider ideal. Or they become beholden to the hedge fund managers – who might easily walk away if pushed too hard relative to their non-captive counterparts.

MyPrivateBanking.com: What should our readers ask their wealth manager with respect to the hedge funds they have in their portfolio?

Richard Bookstaber: The first question to ask, of course, is whose side the wealth manager is on. That is, what is the manager’s financial interest in the hedge fund and in putting client’s money into the fund? After that, the questions I would ask come right out of my recent blog post “The 7 Habits of Highly Suspicious Hedge Funds”:

  • Is there independent risk reporting? One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. People now understand this point for the return numbers. But I believe the risk numbers also must come from a third party getting the fund’s positions and doing the analysis. Otherwise the fund might be changing its risk level – especially if it is underwater – in a gamble to push up returns.

  • Have the risk numbers recently taken a change for the worse? When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports?

  • Is the hedge fund increasing its use of derivatives? In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and the difficulty in marking means that they also can more easily hide losses. Everything else equal, I would take a fund that does not use OTC instruments over one that does. And there should be extra concern if the fund has only recently decided to start using derivatives and swaps.

  • Does the hedge fund have a high level of secrecy? Does the fund have a monolithic, scripted presence to outside investors? Does it invoke it’s need for secrecy to justify limiting access to essential risk information and to its production staff? After what we have learned with Madoff, I would be suspicious of a fund where you or your manager can’t look around the office and talk broadly to those in the production or support spheres.

  • What had been going on with the growth in headcount and lifestyle? Watch out for an “edifice complex”. If a firm has become bloated, if it has had a growing cost base, then it will be more desperate to swing for the fences.

  • What is happening to assets under management? This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

  • Has performance been faltering in recent years? Granted, most everyone was lackluster this past year. So look back at the recent performance even before the 2008 debacle. If the fund has been limping along for the past three to five years, it could be that the space has become too crowded and competitive, or that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. There may be the temptation to increase leverage and risk to try to get back up to the target.

MyPrivateBanking.com: After the disappointing performance of many hedge funds over the last 18 months – should hedge funds still have a major role in the portfolios of private investors?

Richard Bookstaber: Yes, hedge funds as a structure are common sense. In my book, A Demon of Our Own Design, I have a chapter entitled “Hedge Fund Existential”. In it I argue, first of all, that there is no such thing as a hedge fund. That is, there is no quality defined as ‘hedgefundness’. Hedge funds come in so many types, cover so many markets. They all do, however, have the ability to lever and to go short. And this gives them more freedom to take opportunities than the more constrained long only funds. Given two funds with equally talented people, the one that has fewer constraints should be able to perform better. But like a race car versus a sedan, that freedom also increases the opportunity to crash.

MyPrivateBanking.com: Thanks a lot Rick!


My Private Banking



Exclusive Interview: Hedge Fund Expert Richard Bookstaber

"Don't Trust The Numbers Coming Out Of Any Hedge Fund"

  Jun. 25, 2009

Rick

Richard Bookstaber, renown risk management and hedge fund expert, is the author of the book “A Demon of Our Own Design”. He is also the author of three other books and scores of articles on finance topics. Richard Bookstaber worked at Bridgewater Associates, ran the Quantitative Equity Fund at FrontPoint Partners and was in charge of risk management at Moore Capital Management. In the investment banking arena, he served as the managing director in charge of firm-wide risk management at Salomon Brothers and was a member of Salomon's powerful Risk Management Committee. He received numerous awards for his research and holds a PhD from MIT.

In the following exclusive interview with MyPrivateBanking.com Richard explains his views about risk and hedge funds with a special emphasis on the private investor.

MyPrivateBanking.com: Are there important alarm signals regarding hedge funds when the private investor should wake up and call his bank immediately?

Richard Bookstaber: Unfortunately, given the limited information that most funds currently provide, any alarm signals loud enough for the private investor will not come until it is too late. It doesn’t help to make a call after the fund announces that it is down twenty percent. By the way, to make it clear, I am speaking here specifically of market risk-related issues, questions related to taking on improper or extreme risk, or growing too large for a particular market. I am not an expert in the issues related to fraud and outright deception.

MyPrivateBanking.com: How do you view the role of (private) banks and wealth managers as middlemen between investor and hedge funds?

Richard Bookstaber: In theory or in practice? In theory, they should provide oversight and expertise, bring the tough questions to the hedge fund manager, and be the recipients of vital information. And if they can’t get that level of information, they should admit they will be unable to do their job and look elsewhere. In practice, well, we’ve seen what happened with Madoff. Granted that was a small subset of the profession, and there no doubt are many other managers who walked the other way when given the opportunity to invest with him.

MyPrivateBanking.com: Some of the bigger private banks run their own fund of hedge funds. Do you think they provide more protection to the private investor than single hedge funds?

Richard Bookstaber: Again, in theory I can make an argument on why they should. The bank has deep pockets and a broad reputation to defend, so it should be more cautious in making the hedge funds under its purview not do anything that either damages its reputation or leads to a liability. The problem is that the banks often are so large and encumbered as organizations that they cannot provide the level of oversight one might consider ideal. Or they become beholden to the hedge fund managers – who might easily walk away if pushed too hard relative to their non-captive counterparts.

MyPrivateBanking.com: What should our readers ask their wealth manager with respect to the hedge funds they have in their portfolio?

Richard Bookstaber: The first question to ask, of course, is whose side the wealth manager is on. That is, what is the manager’s financial interest in the hedge fund and in putting client’s money into the fund? After that, the questions I would ask come right out of my recent blog post “The 7 Habits of Highly Suspicious Hedge Funds”:

  • Is there independent risk reporting? One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. People now understand this point for the return numbers. But I believe the risk numbers also must come from a third party getting the fund’s positions and doing the analysis. Otherwise the fund might be changing its risk level – especially if it is underwater – in a gamble to push up returns.

  • Have the risk numbers recently taken a change for the worse? When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports?

  • Is the hedge fund increasing its use of derivatives? In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and the difficulty in marking means that they also can more easily hide losses. Everything else equal, I would take a fund that does not use OTC instruments over one that does. And there should be extra concern if the fund has only recently decided to start using derivatives and swaps.

  • Does the hedge fund have a high level of secrecy? Does the fund have a monolithic, scripted presence to outside investors? Does it invoke it’s need for secrecy to justify limiting access to essential risk information and to its production staff? After what we have learned with Madoff, I would be suspicious of a fund where you or your manager can’t look around the office and talk broadly to those in the production or support spheres.

  • What had been going on with the growth in headcount and lifestyle? Watch out for an “edifice complex”. If a firm has become bloated, if it has had a growing cost base, then it will be more desperate to swing for the fences.

  • What is happening to assets under management? This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

  • Has performance been faltering in recent years? Granted, most everyone was lackluster this past year. So look back at the recent performance even before the 2008 debacle. If the fund has been limping along for the past three to five years, it could be that the space has become too crowded and competitive, or that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. There may be the temptation to increase leverage and risk to try to get back up to the target.

MyPrivateBanking.com: After the disappointing performance of many hedge funds over the last 18 months – should hedge funds still have a major role in the portfolios of private investors?

Richard Bookstaber: Yes, hedge funds as a structure are common sense. In my book, A Demon of Our Own Design, I have a chapter entitled “Hedge Fund Existential”. In it I argue, first of all, that there is no such thing as a hedge fund. That is, there is no quality defined as ‘hedgefundness’. Hedge funds come in so many types, cover so many markets. They all do, however, have the ability to lever and to go short. And this gives them more freedom to take opportunities than the more constrained long only funds. Given two funds with equally talented people, the one that has fewer constraints should be able to perform better. But like a race car versus a sedan, that freedom also increases the opportunity to crash.

MyPrivateBanking.com: Thanks a lot Rick!


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