Hedge Funds: The Future

Word on the street and common sense suggest the following short- and medium-term future for hedge funds:

1) On average hedge funds will probably have done not much better or worse than the market as a whole. However, that average performance will hide a lot of extremes. Many funds, thanks to lady luck and leverage will be up record amounts. But that means many funds will be down record amounts too, and the downside is severely limited by zero! Therefore expect to see many funds announcing blow ups soon, maybe 30% of funds will close up shop for one reason or another.

2) After the blow ups expect to see the lawsuits. There will be many managers who have broken the terms of their prospectuses, many will have taken risks that they ought not to have taken. If they made money then they’ll get away with it, if they’ve lost money then they will be on the wrong end of suits for damages. (Not that there’s ever really a right end of a lawsuit!) And there will also be opportunistic suits in cases where no wrong has been done. In the US anybody can sue anyone for anything remember. There will be a three- to six-month delay between the big losses and the big lawsuits. They will take many years before they are completed.

3) When the dust has settled expect to see small, boutique funds being popular. They will have managers with very specialised experience and they will work closely with investors. There will necessarily be more transparency. Because investors will have the upper hand in negotiations leading up to investments expect to see investors taking a shareholding in hedge funds.

The above is what probably will happen. Now for something I personally would like to see happen.

For several years now I have been advising that potential investors in funds really need to take their due diligence far more seriously than they do at the moment. Current practice is that if an investor is very keen on a particular fund, perhaps because of a very persuasive salesman, then they tend not to perform as many background checks as they ought. The reason is simple, if they do the checks then they might find something that means they are unable to invest, therefore they reckon it’s better if they don’t do the checks. This leaves them the freedom to invest where they want. This is naive and dangerous.

In any random walk through life one encounters people who should not be left in charge of a pair of scissors never mind billions of dollars. These are people who, following formative experiences, are excessively risk seeking, or panic in a crisis, or who have a false idea of their own talents or who are simply dishonest. You may be unlucky enough to meet one person with all of these characteristics! Put this person in a sharp suit, send them to how-to-be-a-fund-manager finishing school and, hey presto, you’ve got a front-page Wall Street Journal scandal. There are a lot of clever people out there, people of talent, but how can you tell them from the disasters in waiting? I would very strongly advise that investors take the background checking far more seriously than at present. Speak to managers’ colleagues, partners in previous funds, previous employers and previous employees, etc. Double and triple check CVs and qualifications.

I doubt whether it will catch on, sadly, but I’ve also been advocating for years that there should be a process of psychometric testing, along the line of Myers-Briggs, for fund managers. This is actually not uncommon in other business scenarios involving large loans, buyouts, etc. and ought to be standard practice for any position of serious responsibility.