• Are all hedge fund investors "on their own"? Or are hedge funds fiduciaries?
• What is the nature of representations of hedge funds': advisers, promoters, accountants, consultants, finders, prime brokers, lenders, broker dealers, fund of funds sponsors initial and continuing fiduciary duty to investors?

• Hedge funds and SIVs unregistered, unregulated vehicles lack basic investor protections and contain many serious conflicts of interest,
  •  compensation is improperly inflated due to:
  • value securities as they like, notably CDOs; ABCP collateralized in some cases sub prime mortgage backed securities,
  • often lack independent, objective third party oversight,
  • borrow against inflated collateral in the hopes of juicing returns,
  • often cross invest in affiliated, similarly unregulated investments, reduce transparency,
  • fraudulent counterparties create the illusion of orderly markets for certain securities' valuation,
  • cannot control timing of forced buy-ins of short positions; long-short strategies are very prominent. 
• Sub prime mortgages, packaged and securitized though SIVs as collateralized debt obligations (CDOs) are a recent innovation, most hedge fund managers have little or no previous investment experience.  How did you feel after your first shot of tequila?
• Asset backed securities including ABCP, collateralized by mortgages, credit card receivables, rental cars, even royalties from a music catalog are not fungible, they respresent unique, discreet slices of the underlying assets.
• Unfortunately some Hedge funds, trying to juice profits, borrowed heavily and leveraged their assets, whose valuation depends on liquidity in institutional markets, so called dark pools of liquidity and other means of trading including quantitative, black box, algorithmic trading models premised upon estimated correlations and standard deviation. Today, not surprisingly, some of these "securities" trade only by "appointment".
• Credit rating agencies also known as ISROs:
• S&P, Moody's, Fitch whose fees are paid by issuers (potential conflict of interest), assigned these securities top ratings and proved once again that their ratings lag the markets.  
• Instead they should refocus their ratings assignments on the process of mortgage lending and underwriting by banks and non-banks alike before expressing an opinion on the likelihood of a credit default.
• These problems are when, not if problems; transient, generation low interest rates fueled much of the rise in residential real estate valuations, the very collateral underlying mortgage backed, in particular sub prime mortgage securities.
  • One might ask  credit rating agencies could monitor such increases.  In fact, some have equity research subsidiaries who do, why was the information not shared? More glaringly, S&P states in a Structured Finance "white paper" dated August 23, 2007 on page 9 the following "Market value analysis is a key component of many different structured finance ratings and has been for many years.  All RMBS (Residential mortgage backed securities) ratings require an analysis of residential property values and their movement over time."  Really?  Unsustainable escalation in value of collateral, yet the AAA ratings persisted; emblematic of a preventable, correctable ratings process, one that deserves correction.  (It is improbable not even one of these credit ratings firms' analysts were themselves astounded by the trajectory of valuations of homes in their very own neighborhoods and or communities.)
• Capital, currency and commodities are globally connected.  Settlement of trades is nearly immediate, disruption could unsettle all markets.  Cash infusions by the operators or sponsors, market rescues, liquidity by Federal Reserve Bank through discount rate cuts, extended rollover provisions, open market operations band aid liquidity only; Fed action does not cure the credit (creditworthiness) and or valuation issues of these "securities".
• A potential solution:
  • Technology affords a way to anonymously monitor and align hedge funds and SIVs asset valuation, credit and leverage decisions to banks Basel II principles with a type of capital charge mechanism; but then again global economic growth, (fueled by trade ups and cash out refi's in residential real estate, itself underpinned by eyes-closed mortgage underwriting, generation low interest rates and securitization on steroids) would not have been as robust in the post technology bubble era.  Some investors don't recognize tulips too well.

Can hedge fund investors better protect themselves?

• It begins with understanding BEFORE making an investment in a hedge fund or private placement.
• What is the manager's or team's experience and track record with the specific types of securities, strategies and leverage?
• What risk return pattern was achieved, how does it compare with a normal benchmark?
• A prudent investor needs to devote the time and effort to do a past performance attribution (identify the sources, strategies, conditions and people who were responsible for the track record), determine that it is replicable, apply the specific funds' past and future expected risk return patterns into a portfolio's overall asset allocation and justify it on an ongoing basis.
• A learning point:
  • CalPERs, the largest pension plan in the world, has 10 professionals and 3 consultants devoted to asset allocation; a smart group, access to the best funds, strategies and research.  That's 20,000 man hours a year determining the correct mix, on the equities side, (arguably the asset class with high transparency) they lean towards passive strategies; food for thought.  How many hours is your adviser spending trying to beat the market?
• So before you go and invest in a hedge fund or securities from an unregistered source, make sure you've done your due diligence AND CONTINUE TO PERFORM DUE DILIGENCE, especially if the funds' performance is terrific, every market eventually reverts to the mean.  Wall St. is like a great white shark when it comes to wringing excess returns out of the market.
• Hedge fund or SIV Fraud, Breach of Fiduciary Duty, Mispriced Assets, Misrepresentation, Negligence, Theft, Embezzlement and Ponzi schemes have increased as the popularity of these investment vehicles has risen.
• Initial, ongoing due diligence perfomed by a completely neutral, independent, qualified ACCREDITED INVESTMENT FIDUCIARY ANALYST is an essential  element of the prudent exercise of fiduciary duty.
  
• Attorneys, CPAs, Trustees, Investment Committees and ERISA Pension, Profit Sharing and 401k Plan Sponsors may contact us for objective and authoritative evaluation of the Prudence and Fiduciary Duties involved in any investment including Hedge Fund investments.

Copyright Chris McConnell & Associates 2007.  All rights reserved worldwide.