Trust but verify.

How does one verify representations for an industry that has traditionally been anything but transparent? Serious due diligence. Why should individuals be extremely cautious prior to investing in a hedge fund? The lack of transparency and the challenge of being able to employ real due diligence.

To that end, the hedge fund industry has largely operated on a trust basis and marketing which employs a lot of ‘word of mouth’ introductions. Against that backdrop, this corner of the investing universe is exceptionally challenging.

Without the ability to truly verify assertions made and returns generated by hedge funds, investors in hedge funds allocate capital with greater risk. In spite of these risks, the hedge fund industry has amazingly been able to operate under a fee structure in which investors annually pay 2% of assets and 20% of profits.

I know plenty of individuals who work at hedge funds. As with any undertaking, it would be irresponsible of me or anybody to impugn an entire industry. That said, I have always thought the lack of transparency and lack in the ability to truly verify investing styles and returns as being a significant reason not to invest.

From that standpoint, I was particularly interested to review a research report, Trust and Delegation, recently released by a number of graduate professors in finance:

Stephen Brown is the David S. Loeb Professor of Finance at New York University Stern School of Business; William Goetzmann is the Edwin J. Beinecke Professor of Finance and Management, Yale School of Management; Bing Liang is Professor of Finance, Isenberg School of Management, University of Massachusetts; Christopher Schwarz is Assistant Professor of Finance at the University of California at Irvine. We thank Bob Krause, Hossein Kazemi, and Andrew Lo for helpful comments. We are grateful to HedgeFundDueDiligence.com for providing their data for this research (http://www.hedgefundduediligence.com/).

What did this extensive research report highlight?

Due to imperfect transparency and costly auditing, trust is an essential component of financial intermediation. In this paper we study a comprehensive sample of due diligence reports from a major hedge fund due diligence firm. A routine feature of due diligence is an assessment of integrity. We find that misrepresentation about past legal and regulatory problems is frequent (21%), as is incorrect or unverifiable representations about other topics (28%). Misrepresentation, the failure to use a major auditing firm and the use of internal pricing are significantly related to legal and regulatory problems, indices of operational risk. Due diligence (DD) reports are costly and are only performed when a fund is seriously considered for investment. It is important to control for this conditioning which would otherwise bias cross-sectional analysis. We find that DD reports are typically issued on high return funds three months after the historical performance has peaked. DD reports are also issued at the point of highest cash flow into the fund. This pattern is consistent with return chasing behavior by institutional hedge fund investors.

Wow. Misrepresentations have occurred in 21% to 28% of the hundreds of hedge funds studied.

Honestly, I am not surprised. If hedge fund managers lie about one part of their business, do you think it is all that difficult to lie and misrepresent returns, investment valuations, and other critical parts of their business?

The inability to verify returns is always an opportunity for a hedge fund manager to fudge those returns when the numbers are not good.

This report may not be surprising, but it is enlightening. For those who would like a deeper view into this corner of our financial landscape, please click on the report below.   ~LD