In Focus

April 4, 2005

isky Business is a well-written description of hedge fund risks written by our friends at Knowledge Mosaic, and I recommend reading it.

Everyday, it seems, the risk of investing in hedge funds is reinforced by news reports about hedge fund scams. Some scams involve investors making direct contact with, and direct investments to, hedge funds. Other scams involve an intermediary, sometimes a reputable financial services firm, which recommends the hedge fund to its clients.

That's the case with Manulife Securities' recommendation of the hedge funds offered by Portus Alternative Asset Management, Inc. While Manulife Securities reaped $10 million in fees for referring $240 million in its clients' money to Portus, Manulife Securities now claims that it too was misled by Portus about the nature of its investments. Pending litigation in Canada alleges that these fees were excessive and that Manulife Securities should have known that investors would realize no return on their investment.

With all the news about hedge fund scams, one wonders how hedge funds as a group reportedly continue to perform well. But, as it turns out, even that may be overstated. A new study by Princeton Professor Burton Malkiel, of the Random Walk Down Wall Street, indicates that hedge fund indexes may be issuing misleading performance figures. Malkiel concludes that such reporting is substantially upward biased, for several reasons. First, "backfilling" (or, reporting after the fact) of only favorable past results is allowed. Second, substantial attrition of hedge funds (due to blow-ups and closings) results in a "survivorship bias" which, when corrected, shows that hedge funds have lower returns and are riskier than commonly supposed. Third, there are problems with hedge funds' relying on stale or "managed" prices in pricing their assets.

Moving forward, Professor Malkiel wonders whether there will continue to be ample investment opportunities for all the new and expanding hedge funds. No doubt, the news reports will continue!

— James J. Eccleston
FinancialCounsel.com