Friday, March 18, 2011

Danger danger: The Wall Street Journal has no idea on how to do hedge fund due diligence

About 30 percent of Bronte's portfolio is shorting frauds.  We are very good at identifying frauds: we are experienced and diligent.

Alas some members of the fourth estate – often those with high profile mastheads – have no idea what they are doing.  This article: “Danger danger, thinking of investing in a hedge fund.  Here are some tips for sniffing out potential fraud” is so misguided as to be comical.

Lets state it up front.  There is a single tip that will allow you to avoid almost all the frauds – just one.  The tip is this:

Do not invest in a fund where the fund manager has access to your assets.

Ok – that needs a little explaining but its not complicated.  If – as an American -  you invest in Bronte Capital you don't give us the money.  We are not even legally allowed to take it.  You send the money to Citco.  Citco is the world's largest hedge fund outsource company – but there are alternatives.  David Einhorn's Greenlight Capital uses one of the bigger banks.  There are smaller players such as Spectrum, Conifer and others.

When you send the money to Citco they hold the assets.  We just trade them by issuing instructions to brokers.  However if we asked Citco to send the money to our personal bank account they would (rightly) refuse.  Moreover Citco value our assets every month and they – not us – send the statements to the clients.  We don't do the valuation so we can't fake it.  We don't hold the assets so we can't steal them.

Private clients surprisingly don't get this.  One of my friends runs a successful (albeit small) fund from his home.  People regularly make out checks out to him.  (If you send us money we will say thank you and send it back...)  The core due diligence test is simply not understood by retail clients – and alas the Wall Street Journal perpetuates their ignorance.

And guess who was the custodian for the assets invested in Bernie Madoff's fund.  BMIS – and that stood for Bernie Madoff Investment Securities.  And Bayou- another large fraud.  Well Bayou of course.  How about Astarra – the fraud I exposed in Australia.  Well their custodian was Trio Capital – a small custodian in the rural Australian town of Albury.  And guess what – Trio and Astarra had the same owners!  What about New World Capital Management – a fraud I wrote up but which was never prosecuted: well the perpetrator himself of course.  I could go on and on and on.  It is really easy to spot frauds and the fact they keep reappearing is testament to people not having a clue how to look for one.

If there is a single due diligence lesson then it is this: ensure that your money mangers have an independent custodian and preferably one of the majors.  And the first step in due diligence is this: don't do your due diligence on the fund manager – do it on the custodian.  Ring the custodian through their switch (not on a phone number provided by the fund manager) and confirm statements of the fund manager with the custodian.*

If you do this you are unlikely to get fleeced.  Simple as that.

Rob Curran misguidedly – and in the interest of the financial establishment tells you what his first red-flag in assessing managers is.  I quote:

The Fund Came to You: The Fund Came to You:  While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy. While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy.

Well politely – garbage.  I have written before on how institutional investors are right people to contact when you want to move the fund from $500 million under management to $1.5 billion under management.  They are absolutely useless at finding the hot fund manager with $5 million under management on their way to five years of 30 plus percent returns.  If you used this rule you would never have invested with Warren Buffett when he ran Buffett partnership.  All of the Buffett biographies make clear he approached well-to-do people like local medical specialists.

But its worse.  If you invest in managers that come to you through funds of funds or institutions you will probably wind up paying double-layer fees to get something like the average of all hedge fund managers.  Our initial client sent us the multi-fund manager record for a major (and successful) fund of fund.

(Click to expand).

He thought this these returns were BS.  I was kinder – these returns ok relative to equities over the same period – and more stable and probably ex-ante lower risk – so I believe this fund of funds has added value.  But the returns are not what you get from a couple of clever guys doing smart stuff.  Moreover there is a real danger in going through the institutional managers – which is that you get something that averages near the financial consensus.  And being in a crowd on Wall Street feels safe but it is actually shockingly dangerous.

Anyway my summary is that the number one method of choosing a fund given by Rob Curran (that is avoid one that comes to you) is counterproductive.  And the number one method of proving you are not defrauded rates a very thin method in the Rob Curran article.

And the Rob Curran article annoys me too – because at Bronte we are careful about trying to construct portfolios without regard to the consensus.  We don't look like institutional managers (no suits).  We don't sound like institutional managers (those accents).  And we we don't think like institutional managers (we don't like style boxes and we will happily change styles if market conditions change).  Rob Curran is telling all the WSJ readers to avoid funds like Bronte or Kerrisdale or any of the other thoughtful start-ups out there.**  And if this criticism sounds a little strident then it should be.  He is defending the financial consensus and the big institutions and frankly I don't think the big institutions covered themselves with glory over the last five years.

Secondary steps to chose the individual hedge fund

You know my view – the really good fund managers are outside the consensus.  Ratbags if you will – but ratbags with risk control.  Danny Loeb was a tearaway when he was younger.  [The rumor is that he posted more than 100 thousand messages on chatboards under the moniker of Mr Pink.]  David Einhorn might look like he is 18 (he is preternaturally young) but listen to what he says and he throws grenades.  (Who can forget the stoushes with Allied Capital and Lehman Brothers?)  And these guys are really smart.  And I guess if you want to chose a hedge fund and you don't want to work too hard you could ring them up.  In the mutual fund space my old boss at Platinum in Australia is far less out-there than those two but he is super-smart and he is not afraid to have people disagree with him.

But you would have missed Einhorn and Loeb when they were young and their best returns were mostly when they managed relatively small amounts of money.  Being an initial year investor in either of these funds was frightfully good.  [Incidentally Buffett's best returns were also when he was younger and smaller.  Buffett partnerships returns were substantially better than Berkshire Hathaway.]

So how do you chose a smaller manager?

Well first remember my test: do they hold the assets themselves of give them to a reputable third party to hold.  Don't forget this rule – it solves almost everything.

Then ask how they get the returns.  Leverage levels matter (they should be low – but 120 long 40 short is probably less risky than just 100 long).  Position size matters.  Short positions should generally be small (or using other mechanisms that limit risk like shorting debt rather than equity).  Long positions can be (much) larger.

Then ask them questions.  Pick an industry that you know really well and they profess to know.  If you can't do that work out some other mechanism to check out that they are not talking through their posterior.  (Clever and well thought through shareholder letters are a good start.  A blog is not bad either!)

Finally there is a test which I do (and which has enabled me to see many frauds) but that is seldom done elsewhere.  Match the stated returns to the ex-ante stated positioning.  For example I have disclosed several times on this blog that I am interested in shorting fraudulent Chinese stocks.  It should then come as no surprise that we are doing (very) well this month.

Likewise alas it was well known that Bank of America was our biggest position as it fell back from the 19s to the 11s.  Bank of America was above 19 in March 2010.  Here are our returns:

(These returns are for a separately managed account for our foundation client.)

The Bank of America position wasn't the only reason for the dud-period in the middle.  We are a global fund and measure ourself in US dollars.  The US dollar appreciated sharply through that period (devaluing our largish Euro denominated positions).  We quite explicitly generally do not hedge currency so you would expect to see currency volatility in our returns.  We also had a position in Maguire Preferred (now MPG Preferred) which gave us a wild though profitable ride.

More to the point – this was done primarily with big cap long positions (and small profitable positions in some defaulted preferred securities) and highly diversified and usually small cap shorts.  The positioning is as explained in my lament post.

Finally I have some strong views about prime brokers.  You should use only funds with US domiciled prime brokers for the reasons outlined in this post.

In other words it is pretty easy to do due diligence on us.

Incidentally the question we are asked almost all the time is "how much money do you manage?"  The implication that you need to be large to be good.  I assure you in almost every case returns are negatively correlated to funds under management.  You want the answer to be low - another inversion of the normal presumption.  Large however is the comfort of crowds - a comfort misplaced in markets.

Here are the steps generalized for any small gun hedge fund manager you might want.

Step 1:  Check the independence of the asset custodian.  This is a black-and-white test.  Any gray in the answer then the fund fails.  Period. Actually if it fails email and see if you can get bounties for spotting it.

Step 2:  Are they smart?  Test them on some industry. Bring an expert if you have one. Otherwise carefully read their material.

Step 3: Do they keep the position size and the leverage low enough to be safe?  Shorts must be smaller than longs.

Step 4: Do their returns correlate with what they say?  Focus on the particularly good months and the flat months.

Step 5: Is their brokerage arrangement sound (especially do they use US domiciled prime brokers).

And if you are a rich guy and they ring you out of the blue.  They are either trying to steal from you or they are being entrepreneurial.  Entrepreneurial is good – sometimes very good.

Follow the above steps and you will sort the wheat from chaff.

Is it too much to ask the Wall Street Journal to do the article properly next time?


*If you ring the custodian at a phone number provided by the money manager you could find yourself talking to a Potemkin custodian – just as people who rang advertising agencies at phone numbers provided by CCME would up talking to Potemkin advertising agencies. No kidding.  When someone gives you a reference do not ring the number they give you – ring the switchboard of the company they work at.  Always.

**Kerrisdale is far more aggressive than Bronte.  Their returns are better too.  But I have wondered openly whether aggression and risk are actually that well correlated - and I would use them as a case example.  I have conducted none of the tests described here on Kerrisdale.


Intrinsic Value said...

Well thought out critique as usual John, looks like WSJ is taking one step forward and three step backwards.

I thought the custodian methods would be similar to mutual funds. If you are investing in a perpetual Aust equities fund you are sending the cheques to the actual fund trustee, not perpetual pty ltd.

John Hempton said...

The Australian law is an ass regarding mutual funds (see the Single Responsible Entities stuff).

I have been actively lobbying to change that. (See my submission to the Cooper review - and I recently travelled to Canberra to talk about these things with Treasury).

Its possible but not required to do things right in Australia.

Platinum holds the assets at State Street - the most reputable of the custodians.

The Australian law imposes few if any duties on custodians - one of the big problems with Astarra.


Kyle said...

I've always had a fondness for Australia and since stumbling onto your blog 2 years ago I have an even deeper fondness. I have a small put position that looks like it will pay off on CAGC and if I'm ever in Aussie land I'll buy you a beer. With that said I do have 3 questions. Do you always use short vs. puts? If so, why? Lastly do you post on Yahoo message boards? I have seen a jlhempton post occasionally. I normally feel my IQ heading south when I read or post but sometimes I'm entertained and educated.

John Hempton said...

Glad you have a CAGC position.

I prefer to just flat short the stock. Why? Its cheaper and I have plenty of shorts.

In the time we have run Bronte we have done puts on four stocks for a loser, a big winner and a small winner and a yet-to-be-decided. Its a good hit rate.

But the basic view is that a 2 percent short is a big position. Its a big position because it hurts when you are wrong.

However we use puts when we want to go bigger and we have a date of death. This time we had a date of death - the day the audit was due - so CAGC puts were my big winner.

But almost all our short profits (and they are quite profitable) come from just straight shorts.


As a rule options are REALLY hard to time.


Unknown said...

Dear John- I allocate to hedge funds for a living, and I generally agree with all your comments. There is one thing that you said and I don't get though: that shorts must be smaller than longs. If you are talking about the aggregate position, well, I think it is a general market call and therefore should not be systematically one-sided.

If you are talking about individual position size, I don't see why it should be the case (unless you have a very concentrated portfolio, in which case shorts might grow on you a bit too quickly when wrong). I generally consider that a similar approach to longs and shorts is a sign of a true absolute return mindset.

Additionally- I would add to your list the importance of checking the quality and the robustness of leverage. For example- If you are a Long-Short manager, I would try and understand how and when your Prime Broker could unilaterally change the terms of funding: generally, unless this was negotiated otherwise, PBs have the ability to pull the plug overnight. When you run a large balance sheet in illiquid markets (credit, small caps) this is a significant risk.

Thanks for your efforts on this blog- I always enjoy reading your posts.

John Hempton said...

Laurent -

Send me an email and I will try to explain why. I think the answer deserves a blog post -

Its not THE AGGREGATE SHORTS (I can understand being neutral). But it is the size of the shorts.

15 longs of 7-8 percent each is a fairly diversified long portfolio.

But an 8 percent short is really really dangerous - especially fraud shorts.

Will explain - have before sort of ...


Anonymous said...

I really think you should start publishing your findings more often. (1) By now, it is outright open season on the Chinese reverse-merger scams
(2) You have built enough credibility to move the market (not just CAGC and UTA but in general)
(3) While obviously self-serving, this will focus more people on the stock> this is good as there might be valid arguments against your thesis, or alternatively, valid additions

Good luck--

Jacob said...

hi John,

always a pleasure to read your posts. however, I have one comment on your preference for smaller hedge funds. couldn´t it be survivor-bias that the current well-respected funds did so well in their early years? i.e. it was a great time to invest in them. but then, how many of their rivals went bust?
maybe there is some research out there that could prove or disprove your thesis.

on the other hand, I agree with your comment on using puts vs shorts. as a stock option´s market maker it is almost always a great time to be short premium, because people like to overpay for the insurance.
big shorts can be very painful too, but disasters don´t happen too frequently. it is painful to see puts expire time after time, bleeding more cash in the long run, than taking a major hit once in a while (as long as it doesn´t kill you).

John Hempton said...

You are dead right about survivor bias... survivor bias is a problem.

The frauds are not generally survivors (though Madoff provides an exception). They tend to live fast die young but have great "returns" until they don't.

But the first test removes the frauds.

The second test - leverae - removes the live-fast-die-young type.

The third test - smart and sensible - genunine experts - tends to remove the lucky type.

The fourth test - returns correlating with what they say - is darn useful for that too - because if the returns happen for reasons OTHER THAN WHAT THEY SAY then you can say luck.

And run that test on this blog... was it "luck" that I had a big short position in China Agritech?

Now suppose I had been short Japan because it was a macroeocnomic disaster and said so - and then there was an earthquake. And I had great returns.

Would that be luck?

Its impossible to remove survivor bias from your estimates - but things like correlating ex-ante statements to ex-post returns removes a fair whack of it.


John Hempton said...

In other words Jaap - my tests were at least in part designed to mitigate the effects of survivor bias.


Anonymous said...

really great article. Simple, concise, and correct.

Buffet has said he's 100% confident that he could make 50% returns a year with a much smaller capital pool. Which makes perfect sense.

just need to make sure a smaller fund has good controls.

Michael R said...

Hi, John,

I see a lot on the web comments that this or that hedge fund manager is "talking his book". What does that mean, and is it something I should watch out for?

John Hempton said...

"talking your book" advocating positions you have in the hope interest in them and hence price of them might go up rather than talking about the world as it is.

Most pejoratively used when a fund manager is trying to promote their way out of a losing position.

Anonymous said...


Whats the plan with your fund? Are you going to offer it to retail investors in Australia. Try to become the next platinum? Or would that raise too much money.

John Hempton said...

The portfolio we have (and hence our returns) would not be possible with billions under management.

Having worked at a shop that manages 20 billion I can assure you to do it well is amazingly hard work. I am not sure I want to go there - and frankly the team does not currently have the skills to go there.

I would like to open an Australian domiciled hedge fund at some stage - but am unwilling to cut the fees to do it and the establishment costs are high which means we will only do it if worthwhile. But hey if you want to talk?

Send me an email.


John Hempton said...

Finally re an Australian fund. The returns don't look so pretty measured in AUD. (They are still acceptable - but it was tough fighting the AUD.)

I suspect that the AUD will not give us so much grief in the future but I have no competitive advantage in picking currency and I am apt to be wrong.

Anonymous said...

When you say "asset custodian" are you referring to the administrator? I am U.S. based, and the administrator handles investor inflows/outflows as well as reporting performance to investors. I am not sure if they are synonymous or you're referring to something different.

Unknown said...


Regarding Custody: If a small fund, that in almost every way satisfies the requirements...custodies the money at their Prime Broker which is a well known company, is this satisfactory? Or should the fund add yet a further level of separation?

Avi player said...

I enjoy every single post from you and kindly support your opinion on this question.

John Hempton said...

The money at the prime broker is OK provided the back office (say CITCO) and not the hedge fund holds the right to withdraw from the broker.

No intermediate back office - no start.

The question is can the hedge fund write a check to itself without you knowing and without your approval?

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