The Habits of Hedge Funds » New Jersey CFO

The New ‘Let Them Eat Cake’ – Taibbi

The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Great American Heist, The Growing American Fascist State, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Joy of Being A Bank, The Judeo-Christian Political Coalition, The Suffering Poor, Time For A New Third Party 1 Response »

Jul 162011

If you think your local Andy Griffith is a greedy pig because he retired in his forties and built an addition to his garage with your tax money, try hanging out with a guy who eats $400 crabs, throws himself $5 million parties where he is serenaded by Rod Stewart and Patti Labelle (who sang “Happy Birthday”), and then compares the president to Hitler when word leaks out that he might have to pay taxes at the same rate as a firefighter or a kindergarten teacher.

But America never gets to meet that guy, because all of those parties are invite-only, and the only reporters that go tend to do so with kneepads on — like the extraordinary Andrew Ross Sorkin, who as Sirota notes, predictably wrote a slurpilicious “In Defense of Schwarzman” piece after the event (his thesis, to the extent that I could make it out, seemed to be that there are even bigger assholes than Schwarzman). As a result, the popular outrage gets steered toward state employees greedily living off their own pensions, not toward the truly deserving targets hiding in the Hamptons and Gstaad and St. Tropez.

The New ‘Let Them Eat Cake’ – Taibbi

The Rise of the Wrecking-Ball Right

A Moral Question - Not A Political One, A State of Distress, BANK RESERVES FOR TBTF, Bilderbergers 1 USA 0, Constitutional Questions, Coup d'etat in America, Deleveraging, Devaluation, Dismal Science-Ignorant Scientists?, Economic Analysis Isn't Science, Federal Reserve-Discussion, Figures don't lie but Liars can figure, Goldman: Underwriter or Undertaker?, Greenspan is kind of stupid, HEY AMERICA-STICK 'EM UP!, History of Finance, Insolvency, Integrity and Responsibility, Is The Market Rally Real?, IT'S ALL ABOUT POWER AND MONEY, Jacksonian Democracy, Moral Hazard, Obama's Hypocrisy, Objectivism, Our phony middle class, Patience is a virtue...Delusion is a vice, Political Chaos, Regulatory Failures, Robert Reich, Small Business-Bedrock of America, Smaller Can Be Better, Subsidiarity, TARP fruit loops, The American Financial Oligarchy, The Big Fat Greek Question, The Consequences of Greed, The Democrats Blew It Again, The Dollar's Demise, The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Growing American Fascist State, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Judeo-Christian Political Coalition, The Obama OMG magic factory, The Sorry State Of American Manufacturing, The Suffering Poor, Time For A New Third Party, Truth In Charity, Unemployment Catastrophe, Unindicted Co-Conspiritors, Unintended Consequences, USA Is the New Japan, Wage Deflation, We Are All Cooked, We Are All Guilty, We Have Become Beggars To The World, Who owns Congress-Still! 1 Response »

Jul 162011

One would have thought the last few years of mine disasters, exploding oil rigs, nuclear meltdowns, malfeasance on Wall Street, wildly-escalating costs of health insurance, rip-roaring CEO pay, and mass layoffs would have offered a singular opportunity to explain why the nation’s collective well-being requires a strong and effective government representing the interests of average people.

The Rise of the Wrecking-Ball Right

At a time when corporate profits are through the roof, the Dow is flirting with 12,000, Wall Street paychecks are fat again, and big corporations are sitting on more than $1 trillion in cash, you’d expect jobs be coming back. But you’d be wrong.

The U.S. economy added just 36,000 jobs in January, according to today’s report from the Bureau of Labor Statistics. Remember, 125,000 are needed just to keep up with the increase in the population of Americans wanting and needing work. And 300,000 a month are needed — continuously, for five years — if we’re to get back to anything like the employment we had before the Great Recession.

In other words, today’s employment report should be sending alarm bells all over official Washington. Granted, unusually bad weather may have accounted for some of the reluctance of employers to hire in January. But even considering the weather, the economy is still terribly sick. (Technical note: The official rate of unemployment fell to 9 percent from 9.4 percent, but that’s because more workers have left the labor market, too discouraged to continue looking for work. The official rate reflects how many people are actively looking for work.)

We have two economies. The first is in recovery. The second remains in a continuous depression.

The first is a professional, college-educated, high-wage economy centered in New York and Washington, that’s living well off of global corporate profits. Corporations continue to make money by selling abroad from their foreign operations while cutting costs (especially labor) here at home. Wall Street is making money by taking the Fed’s free money and speculating with it. The richest 10 percent of Americans, holding 90 percent of all financial assets, are riding the wave. And their upscale spending has given high-end retailers and producers a bounce.

The second is most of the rest of America, and it’s still struggling with a mountain of debt, declining home prices, and job losses. In coming months most Americans will also be contending with sharply rising prices of food and fuel.

Our representatives in Washington see and hear mostly the first economy. The business press reports mainly on the first economy. Corporate and Wall Street economists are concerned largely with the first economy.

But the second economy will determine our politics in 2012 and beyond.

And not even the first can be sustained permanently on its own. Corporate profits cannot continue to rise on the basis of foreign sales (which are slowing as Europe adopts austerity and China raises interest rates), the purchases of the richest 10 percent of Americans (which are dependent on a rising stock market), and cost-cutting measures at home (which are necessarily limited). Without a strong and broadly-based middle-class recovery, America’s big money economy will fall in on itself. A major stock market “correction” is a certainty.

Robert Reich is the author of Aftershock: The Next Economy and America’s Future, now in bookstores. This post originally appeared at RobertReich.org.

The Jobs Report & America’s Two Economies – Robert Reich, Huffington Post

Bad Meat

Secularized Lending, The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Global Economy, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Joy of Being A Bank, The Judeo-Christian Political Coalition, The New American Socialism, The Sorry State Of American Manufacturing, The Suffering Poor, The Summers Exit Watch, Time For A New Third Party No Responses »

Jun 192010

MAD MEAT! How Securitized Lending Collapsed the Financial System, Eric Von Berg (a commercial property mortgage banker and was the President of the California Mortgage Bankers Association during the heat of the market who has been watching “Regulatory Reform” as a member of the Commercial Board of Governors of the Mortgage Bankers Association of America). This is an absolutely must read! It has a few pages of set up to a fable of sorts, but when you get to page 6 of the slide presentation, it becomes laser sharp and funny. To wit:

The disclosures were typically so numerous and far fetched that the real risks were overlooked…

Sponsor Disclosure. Sponsor has various conflicts of interest. Not printed: We set up a book making operation taking bets on whether you will get sick and die from this product. Are we also making bets? “You betcha!” Which side are we betting on? According to the SEC, we are allowed to tell you, “None of your business!”

Hat Tip to Naked Capitalism

Wall Street Big Fish Stink From The Head Down

The American Financial Oligarchy, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Habits of Hedge Funds, The Importance of Strategic Planning, The Intrusion of UNLAWFUL Authority, The Summers Exit Watch, THEY ARE ALL THE SAME, Those Quarky Accounting Rules, Time For A New Third Party, Truth In Charity, Who Guarantees the Guarantor?-You Do! No Responses »

Apr 242010

Obama’s financial reform will fail because all the masters of the universe know how to do is make money.

Wall Street’s Big Fish Stink From The Head Down – Robert Lenzner, Forbes

U.S. Is Riskier Than Euro Zone; So Says CDS Market

TARP fruit loops, The Bear Facts, The excellent adventures of Ben Bernanke, The Habits of Hedge Funds, USA Is the New Japan No Responses »

Mar 262010

As the folks at Standard Poor’s Valuation and Risk Strategies division noted in a research note Monday, the difference between the spread on U.S. sovereign credit default swaps and an equivalent benchmark for AAA-rated euro-zone sovereigns flipped into positive territory March 12. As U.S. CDS spreads expanded to their widest levels in two years, that cross-region gap blew out to 5.7 basis points last Friday before narrowing to 4.7 Tuesday.

Wider CDS spreads indicate that sellers of insurance against a particular issuer’s default are charging more for it. In effect, the positive U.S.-versus-euro zone spread means investors think the risk of a U.S. default–however remote–is greater than that on euro-denominated sovereign debt.

So much for the view that low inflation and loose monetary policy make for a rosier debt outlook for Treasurys than for the debt of crisis-hit euro-zone sovereigns.

Wall Street Journal

What they knew and when they knew it

A Growing List Of One Term Presidents, A Moral Question - Not A Political One, A State of Distress, A Time To Repent, AIG and all that....., Audit the auditors?, Bilderbergers 1 USA 0, Coming Social Unrest, Commercial Real Estate Bust, Consumption Ran the Old Economy, Coup d'etat in America, Federal Reserve-Discussion, Having Fun With Derivatives, Insolvency, Integrity and Responsibility, IT'S ALL ABOUT POWER AND MONEY, No Bank Is Indispensable, Obama's Hypocrisy, Our phony middle class, Political Chaos, Political Implications, Regulatory Failures, Ron Paul Stands Tall, Securitization, Stress Test Mess, Sub-Prime anytime, TARP fruit loops, The Arrogance of Power, The Consequences of Greed, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Habits of Hedge Funds, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Judeo-Christian Political Coalition, Time For A New Third Party No Responses »

Jan 312010

“I have to think this train is probably going to leave the station soon and we need to focus our efforts on explaining the story as best we can. There were too many people involved in the deals — too many counterparties, too many lawyers and advisors, too many people from AIG — to keep a determined Congress from the information.” James P. Bergin, NY Fed, in an email to his Fed colleagues

‘Though it is hard to divine much understanding from the unredacted filing, it has become clear that Goldman had more involvement than previously believed: In addition to the credit default swaps it bought from AIG, the filing shows that Goldman Sachs also originated many of the underlying assets that AIG and the New York Fed bought back from Société Générale.

The American people have the right to know how their tax dollars were spent and who benefited most from this back-door bailout,” said Kurt Bardella, spokesman for Issa. “Now that it’s public, let’s see if the sky really does fall as the New York Fed said it would to justify its coverup.”

Other lawmakers believed that the New York Fed was trying to hide its ties to Goldman Sachs.’ AIG Reveals the Story – CNN

“Wednesday’s hearing described a secretive group deploying billions of dollars to favored banks, operating with little oversight by the public or elected officials.

We’re talking about the Federal Reserve Bank of New York, whose role as the most influential part of the federal-reserve system — apart from the matter of AIG’s bailout — deserves further congressional scrutiny…

By pursuing this line of inquiry, the hearing revealed some of the inner workings of the New York Fed and the outsized role it plays in banking. This insight is especially valuable given that the New York Fed is a quasi-governmental institution that isn’t subject to citizen intrusions such as freedom of information requests, unlike the Federal Reserve.

This impenetrability comes in handy since the bank is the preferred vehicle for many of the Fed’s bailout programs. It’s as though the New York Fed was a black-ops outfit for the nation’s central bank…

New York Fed staff and outside lawyers from Davis Polk & Wardell edited AIG communications to investors and intervened with the Securities and Exchange Commission to shield details about the buyout transactions, according to a report by Issa.

That the New York Fed, a quasi-governmental body, was able to push around the SEC, an executive-branch agency, deserves a congressional hearing all by itself.” Secret Banking Cabal Emerges From AIG Shadows – Reilly – Bloomberg

Hat Tip to : Jesse

NY Fed Conspired to Hide Details of AIG Bailouts from Public and Congress

Sic transit America?

A Growing List Of One Term Presidents, A State of Distress, A Time To Repent, AIG and all that....., “the Greenspan doctrine”, Back to the basics, Collateral Damage, Coming Social Unrest, Commercial Real Estate Bust, Consumption Ran the Old Economy, Coup d'etat in America, Death of the Dollar, Deflation-Inflation-Stagflation, Devaluation, Dismal Science-Ignorant Scientists?, Even the Terminator Can't Help California, Federal Reserve-Discussion, Figures don't lie but Liars can figure, Integrity and Responsibility, Is The Market Rally Real?, It Is Nice To Be Part of the Elite!, It starts with a foundation, IT'S ALL ABOUT POWER AND MONEY, Monetary Policy - Discussion, Our phony middle class, Patience is a virtue...Delusion is a vice, Political Chaos, Politicians, Prostitutes and Pimps All Rhyme, Small Business-Bedrock of America, Sub-Prime anytime, TARP fruit loops, The Arrogance of Power, The Consequences of Greed, The Democrats Blew It Again, The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Global Economy, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Judeo-Christian Political Coalition, The New American Socialism, The Sorry State Of American Manufacturing, Time For A New Third Party, Truth In Charity, Unemployment Catastrophe, US Trade Imbalance, USA Is the New Japan, We Are All Cooked, We Are All Guilty, We Have Become Beggars To The World No Responses »

Jan 162010

Flagging: a US sailor stands on the flight deck of the aircraft carrier USS George Washington

If a week is a long time in politics, a decade is starting to look like an age in geopolitics. Comparing the America that began the 21st century with the America of today is to witness a country that has in some ways quite radically altered its view of itself and its relationship to the world.

In short, the metallic rust of decline has crept into the American soul. “You could argue that the first decade of the 21st century was the last decade of the American century,” says David Rothkopf, a former Clinton administration official and student of US foreign policy. “We are now entering the multipolar century.”

Self-doubt tarnishes Brand America

The Big Government Boss isn’t going away

A Growing List Of One Term Presidents, A Shareholder-Not Just a "Stakeholder", A State of Distress, AIG and all that....., Analysis & Commentary, “the Greenspan doctrine”, Coming Social Unrest, Commercial Real Estate Bust, Deflation-Inflation-Stagflation, Is Goldman Sachs Evil?, It starts with a foundation, IT'S ALL ABOUT POWER AND MONEY, No Bank Is Indispensable, Obama's Hypocrisy, Our phony middle class, Political Chaos, Regulatory Failures, Small Business-Bedrock of America, Smaller Can Be Better, Socialism, TARP fruit loops, The Arrogance of Power, The Consequences of Greed, The Democrats Blew It Again, The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Joy of Being A Bank, The New American Socialism, Unemployment Catastrophe, Unindicted Co-Conspiritors, Wage Deflation, We Have Become Beggars To The World, Who Guarantees the Guarantor?-You Do!, Who owns Congress-Still! No Responses »

Nov 212009

“Hindsight is a wonderful thing,” said Timothy W. Long, the chief bank
examiner for the Office of the Comptroller of the Currency. “At the height of
the economic boom, to take an aggressive supervisory approach and tell people to
stop lending is hard to do.” Post Mortems Reveal Obvious Risks at Banks, NY Times

Thinking through central bank independence

Federal Reserve-Discussion, The End of American Capitalism As We Know It? - Discuss, The excellent adventures of Ben Bernanke, The Financial Elite, The Geithner Resignation Watch, The Habits of Hedge Funds, The Importance of Strategic Planning, The Inherent Disorder of Empires, The Intrusion of UNLAWFUL Authority, The Joy of Being A Bank, The New American Socialism No Responses »

Oct 252009

I have a column in Financial Express today on the rationale for independence of the central bank, and how this is operationalised in democracies.

The rationale for central bank independence

The starting point of modern thinking on monetary policy is the issue of central bank independence. Watching the world across the centuries, a pattern has been found that non-independent central banks distort monetary policy to support the incumbent political party. When elections are approaching, rates tend to be dropped. This makes households feel a bit happier and more inclined to vote for the incumbent. This threatens the fairness of elections. And after elections, it tends to kick off higher inflation. Non-independent central banks are thus associated with election-induced fluctuations. Instead of monetary policy being a force for stability, it becomes (to some extent) a source of shocks for the economy, and of unfairness in elections.

Major countries have chosen a remarkable solution: politicians relinquish control over the central bank. This is a truly rare feature in public administration. In almost all other elements of government, democracies work by holding politicians accountable in elections, and giving politicians the reins in public administration. In this one area, the world has done something unusual.

This requires accountability mechanisms

Two issues follow hard on the heels of independence. First, independence goes with a narrowing of the functions of the central bank. There is no economic case for having independence from politicians for functions such as running the payments system, regulating or supervising financial markets or banks, running a bond exchange and depository, manning a system of capital controls, etc. The rationale for independence is limited to one specific problem: that of setting the short-term interest rate of the economy. Hence, giving RBI independence requires narrowing down its functions to the core where economic logic suggests independence. All other functions need to be placed in conventional agencies, with control in the hands of accountable politicians.

The second issue is that of accountability. The standard route of accountability through elections is being eschewed in this unique problem. But a central bank cannot be handed over to a set of unelected officials with no accountability. This would induce abuse of power, where the agency will focus on its own interests at the expense of the country.

The solution involves transparency, predictability and inflation targeting. The agency must be fully transparent about everything that it does. It must use rules rather than discretion, so as to limit the extent to which discretionary power is wielded by unelected officials. They must write down a monetary policy rule, discuss this in public, and live by it. The third element of accountability is inflation targeting. Independent central banks must have a quantitative monitorable target. Setting an inflation target for the medium term binds the agency to achieving a goal, as opposed to arbitrary exercise of power without accountability.

Commen sense and monetary economics come together

All this reasoning is rooted in the basic hygeine of good public administration. Once we accept the starting premise — that central bank independence is desirable — then careful thinking about public administration leads us to the remaining conclusions: narrow the functions placed in an independent central bank to only those where independence is required (i.e. setting the short-term interest rate), have full transparency, have a monetary policy rule, and require inflation targeting.

In historical sequence, the above reasoning led the way in monetary policy reform. It was a bit later that the best monetary economists started closing their models by putting in an inflation targeting central bank. They found it works very well. So in this strategy for monetary policy reform, we have a happy consensus between the common sense of good administrators and the state of the art of monetary economics. The central banks of the bulk of OECD GDP are now de facto or de jureDe jure inflation targeting is particularly important in countries with weak institutions, where the behaviour of an agency that is not tied down by law can be more erratic. inflation targeting, and the emerging markets with high standards of governance have also made the switch.

Indian monetary policy reform

The Indian monetary policy debate is about the key ideas of the successor to the RBI Act of 1934, which was drafted by the British in the 1920s. The authors of this act never envisioned the conditions of 2009, either in terms of the Indian economy, or our knowledge of monetary economics. In this debate, RBI staff are interested parties and have to recuse themselves.

Operationalising inflation targeting involves addressing many practical problems. A focus on these practical problems is premature. All these practical problems can be solved – as has been done myriad times in other countries – once the principle is accepted. The existence of these practical problems does not invalidate the basic strategy.

One periodically encounters criticism of low inflation as the prime goal of monetary policy. However, anyone who proposes that inflation targeting is not the answer has to come up with an alternative accountability mechanism, for no democracy can have an independent central bank without accountability. In addition, advocates of novel schemes have to explain why India should be a guinea pig for something not found in good countries.

The 7 Habits of Highly Suspicious Hedge Funds

The Habits of Hedge Funds No Responses »

Sep 252009

You’ve heard this story before: A trader at a bank is knocking the cover off the ball. His success garners political power within the bank. He creates a fiefdom that insulates him from the rest of the firm; his trading group explodes in size. He lives a conspicuous, extravagant lifestyle. His ego alienates the management and intimidates the support staff. Then the trader hits a rough patch. He uses all the tricks in the book to keep his poor results under wraps while he tries to find a way to recoup. Everyone is gunning for him, so he has to get back into the black, and fast.

How does he try to do that? He ratchets up his risk. He knows he won’t be able to turn it around fast enough if he plays it prudently, whereas there is some chance to stay in the game if he bets it all on 00, or better yet, if he levers up as much as he can, borrows all the money he can get his hands on, and then bets all of that on 00. If he loses, well, he was going to be gone anyway, so he may as well try for the big time.

That is one of the reasons there are risk managers. Risk managers know to put extra focus on traders who are struggling and, for that matter, on traders who seem to have an eerily hot hand. Especially if those traders have the ability to lever and to obscure their risk through the use of sophisticated instruments.

This story is now primed to play out in the hedge fund space. How many hedge funds do you know that more or less fit this description: A hedge fund manager had a run of great returns. His fund has grown by leaps and bounds. He has doubled his staff year after year in anticipation of even greater things to come. He has enjoyed a Page Six lifestyle; he is the belle of the ball, his dance card always filled. But now his kingdom is under siege. Assets under management have dropped precipitously due to redemptions layered on top of poor trading results. The investors that remain are demanding reductions in management fees. Incentive fees are gone until he scales the wall to get back to high water mark. With the way his operation has ballooned, he realizes that if he doesn’t make serious returns over the next few years, he will be crushed under the costs and the dwindling asset base.

What does he do? If he follows the same course as the trader at the bank, he will try to find ways to take on more risk. Of course, any investment fund might face the same temptation, but hedge funds have more tools at their disposal to make good on the try. Hedge funds can lever, delve into wide-ranging and risky markets and readily employ the so-called innovative securities to increase risk in ways that are difficult to discern. And unlike the trader at the bank, the hedge fund can operate without anyone seeing what it is doing. No one is looking over its shoulder at the trading positions each night.

Is the risk management in place to deal with this scenario? Here are seven “habits” that an investor should look out for:

1. No independent risk reporting.

One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. Or, at least, trust but verify. If things go wrong and that is what you relied on, you will look like a fool, or worse. The risk numbers must come from having a third party getting the fund’s positions and doing the analysis.

The risk reporting must go beyond the VaR numbers to include measures of leverage, concentration, degree of diversification and size in markets (to assess liquidity risk). Again, all independently provided.

The diversification and concentration are necessary because, as we now know all too well, the relationships between markets can change. These risk measures cannot be calculated simply by knowing how many markets the fund is trading. It is critical to know how linked the markets are; how concentrated positions are when aggregated across similar markets. With globalization, diversification opportunities aren’t what they used to be. And in any case, it isn’t much value to be active in twenty markets if two-thirds of the positions are in three or four markets that are closely related.

2. A change for the worse in the critical risk numbers.

When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports? For example, is the third-party view of leverage, liquidity or diversification as favorable as has been represented by the fund itself, both now and historically?

3. Increased use of derivatives.

In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and difficulty in marking means that they also can more easily hide losses. There should be extra concern if the fund has only recently decided to start using derivatives and swaps.

4. High level of secrecy.

Does the fund have a monolithic, scripted presence to outside investors? Does it obscure its approach with secret formulas and strategies? Does it invoke its need for secrecy to justify limiting access to essential risk information and to its production staff? If so, you might want to get ready for a Madoff moment.

5. Growth in headcount and lifestyle.

This is the firm’s equivalent of the trader’s lifestyle. The fund’s principles can stretch the envelope in terms of personal lifestyle, and, unlike their banker cousins, their firm is their own domain. They can get an “edifice complex”. If a firm has become bloated, if it has a growing cost base that forces it to be impatient, then it will be more desperate to swing for the fences.

6. Decline in assets under management.

This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

Related to this, is the fund far below high water mark? Hedge funds make money from fixed management fees based on assets under management and incentive fees based on the return they generate for their clients. Most hedge funds only start collecting the incentive fees after they get back to high water mark. If a hedge fund is thirty percent below high water market, it may need years of strong returns before any money starts ringing up in the incentive fee register.

7. Lackluster performance in recent years.

Most everyone was lackluster this past year. So you should look back at the recent performance before the 2008 debacle. A comparison of the performance over the past three to five years versus the performance in the more distant past can be an indicator of a failure of the fund’s inherent strategy. It could be that the space has become too crowded and competitive, that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. If things have been slowly petering out, if alpha has been diminishing, then more leverage and risk is needed to get back up to the target.

Or, in desperation, the fund might try something new. So a related phenomenon will be style drift or a move into new markets and strategies. Style drift can be an indication that the bread and butter strategy is not pulling its weight. Is there movement toward new markets, a.k.a. ‘new opportunities’. Is an equity fund hiring expertise to gear up in credit, is a macro fund starting to trade volatility? Not everyone standing in the shadows is a mugger. And sometimes a cigar is just a cigar. Although “habits” like a lack of independent reporting are pretty obvious weaknesses, others, such as exploring new trading strategies, might be justifiable. But these are warning signs that justify deeper questioning and tighter oversight.

Originally published at Rick Bookstaber’s Blog and reproduced here with the author’s permission.