Fiduciary Magazine

Archive for the ‘Due Dili’ Category

When markets get hammered, you see a lot of ponzi schemes undone. That’s because when the market craps out, no one puts new money into the market and the schemer can’t maintain his lifestyle and meet client redemptions at the same time.

Scott Rothstein, who swindled $1 billion from his clients was sentenced to 50 years today. He committed his crimes while licensed as an attorney. That’s a new take on attorney – client privilege.

But Rothstein isn’t the only dirtbag to get press.

Kenneth I. Starr, a Manhattan business manager and investment adviser, was found hiding – creatively – in a closet and was arrested for conning some of Hollywood’s best known stars out of millions. According to the NYT, “he was arrested on May 27. He remains behind bars at the Metropolitan Correctional Center in downtown Manhattan, after prosecutors argued that he might flee if released on bail.”

Dana Giacchetto and his Casandra Group Investment firm advised Mike Ovitz, Rick Yorn, and Leonardo. Giacchetto was in jail for stealing some $20 million from his star clients.

No one is safe people. You have to do your homework, even if you get referred to someone. You need to get their DNA code.

Here are some helpful links:

FINRA Brokercheck for people who work at brokerage firms.

Investment Advisor Public Disclosure for firms that claim to be Investment Advisors or Independent Advisors. You can also check if their asset under management claims are correct with this site.

National Futures Association’s Background Affiliation Status Information Center (BASIC) is to check the compliance history of those who are in the commodity futures business.

Plenty written and spoken about Goldman Sachs since the SEC has come forward with charges. Now, CNBC has learned that Paolo Pellegrini has insight that contradicts what the SEC has alleged.

Paolo Pellegrini told the government that he informed ACA Management that Paulson intended to bet against, or short, a portfolio of mortgages ACA was assembling.

CNBC has examined documents in which a government official asked Pellegrini whether he informed ACA CDO manager Laura Schwartz about Paulson’s position.

“Did you tell her that you were interested in taking a short position in Abacus?” a government official asked Pellegrini, referring to the name of the CDO portfolio.

“Yes, that was the purpose of the meeting,” Pellegrini responded.

Here is the full article at Yahoo! Finance.

If you have your money with someone who is the investment advisor (unregistered to boot!), the custodian, and the broker / dealer at the same time, YOU are to blame for getting scammed. Blaming the SEC feels good – and there’s no doubt there’s holes there – but in the end we are responsible for our money.

I was at a presentation where one large allocator, Robert Schulman from Tremont, called Madoff “god.” Madoff’s investors were proud people and they bragged about “being with Bernie.”

Blaming other forfeits your power. Financial literacy is about managing risk, not being able to quote Suze Orman.

By Andre Peschong

Looking at the fallout on Wall Street, there has been great change in the financial industry and, in turn, some unintended consequences. The hedge funds that once numbered over 7,000 (my unofficial estimate as I couldn’t find a substantiated number) are now pared down to around 3,000. Venture Capital has retreated to higher ground by doing larger deals and more 2nd, 3rd and 4th rounds into existing portfolio companies. Private equity houses have largely been untouched, but they are suffering from the lack of exits. Three of the largest investment banking firms have gone under or been absorbed by larger traditional banks.

What are the unintended consequences of this current market upheaval for the financial sector? The most glaring one follows the first law of thermodynamics (and I paraphrase) which portends that nothing is ever created or destroyed but merely shifts forms. The shift I am alluding to is the movement of talent and deals at these former large tier investment banking firms to new firms, or to more aggressive mid tier boutique investment banks or specialty M&A houses.

This shift takes time, which is probably a contributing reason for the lack of IPO’s, PIPE transactions or any other type of liquidity events for the private equity/VC market.

Need proof? According to Price Waterhouse Coopers (PWC) the VC activity for the first quarter is down to levels not seen since 1997. VC and private equity funds have to consider the types of deals and companies they are willing to invest in based primarily on the extended holding time. The only current exit for a privately backed company is through an M&A transaction and those deals will be done at increasingly smaller multiples as this is a buyers’ market. The events of the past 12 months have really made professional investors and funds alike re-examine their investment model, pricing and exit strategies. The unintended consequence of these events are a boon to M&A boutiques that concentrate on buyside representation or that have top tier clients looking for bolt on acquisitions.

The market needs time to readjust to the new landscape in the capital markets. Deals will be under much heavier scrutiny from all sides, the accountants, VC’s, private equity groups, valuation firms, investment banks etc. This shift in due diligence on transactions will be significant. There will be a natural growth of service providers bringing additional transparency to the “deal” business. A true and needed unintended consequence.

By Aleksey Matiychenko and Gregory Dyra — April and May have been tremendous months for global financial markets. MSCI World Index rose 11.49% and 9.52% respectively. While the index is currently down 83 basis points in June, it is up 7.46% for the year. The world as a whole seemed to perform better than did U.S. While S&P rose 15.2% from March 31, 2009 through May 29, 2009, by June 22 the index was only up 2% for the year. Emerging markets, on the other hand, are now up more than 32% year to date.

It seems that hedge funds have been able to ride the up market well. The Barclay Hedge Fund Index is now up more than 10% through the end of May with all hedge fund strategies posting positive performance. Perhaps proving the existence of mean reversion, the biggest losers of 2008 posted the best performance in 2009 so far. Convertible Arbitrage Strategy that lost 27.66% in 2008 is up 19.18% through end of May. While the Emerging markets strategy lost 39.57% in 2008, it is now up 21.29% year to date.

While the hedge fund industry has shown signs of recovery, there has not been a tremendous increase in the launching of new funds. Based on the Barclays database we estimate that about 40 funds have been launched so far this year. This figure is even exaggerated since it includes multiple share classes of some of the funds. In comparison more than 1,900 funds were launched in the first five months of 2008. As of June 6, 2009 about 300 funds have not reported performance for April 2009.

While some reports suggest that the outflow of capital from the hedge fund industry has slowed, the industry remains in a transitional or rather transformational stage. In the post Madoff world, the days of happy, trusting Goldilocks approach to picking hedge fund managers are over. The Madoff case served as a catalyst to shift investors’ views on how to select, evaluate and invest in hedge fund managers. The initial kneejerk reaction promoted conversations of investing only in fully transparent and liquid hedge funds via Managed Account structure. While it’s unlikely that hedge fund industry will shift entirely into Managed Account structure, it’s clear that hedge funds that want to survive in the new world will need to adjust to tougher demands from their investors.

The three most popular demands that are likely to be imposed on surviving funds are lower fees, better liquidity and better (full) transparency.

In this column, we briefly touch on the first two and discuss the last one in more detail.

Fees

Hedge fund managers typically make money from a combination of the management and performance fees. Most funds have High Water Mark provisions that imply that the funds cannot charge performance fees after suffering losses until those losses are recouped by the investor. After suffering the worst year in 2008, most hedge funds are not likely to collect performance fees in 2009. It’s likely that the standard “2 & 20” model will change in the future, though, it’s unlikely that the fees will fall significantly as they will become even more essential for covering funds’ operating expenses.

Liquidity

Liquidity, or rather lack of it, can be blamed for many problems related to the current crisis. Anecdotally we have seen the trend in launches of more liquid fund of funds products. Managed accounts with weekly or daily liquidity seem to be in fashion for now. The liquid/managed account structure has certain advantages since it provides investors with transparency, liquidity and control of their portfolios. Not all hedge fund strategies, however, lend themselves to such structure. It seems unlikely that the hedge fund industry will shrink down to just Equity Long/Short, Equity Market Neutral and CTA strategies (the strategies that are most suitable for the managed account structure).

Transparency

Perhaps one of the biggest complaints about hedge funds is the lack of transparency. The press and the media describe hedge funds as opaque investment vehicles striving on secrecy and open only to the rich. Many investors blame that alleged opaqueness for many of the financial problems that we are experiencing right now. Some demand full transparency.

While some of the criticism is valid, it would not be fair to just say that all hedge funds are secretive and opaque. In this article we touch on three main topics related to transparency: the current state of hedge fund transparency, pros and (mostly) cons of full transparency, and our own view.

Current State of Hedge Fund Transparency

Hedge Fund transparency in the current state ranges from the Black Box Model on one side to the Full Transparency model on the other side. The most secretive funds provide their investors with monthly return and general leverage information. The leverage information is typically provided in the form of percent of equity allocated to long and short positions. These funds may disclose more information in due diligence meetings and conference calls, but most often will not report this information in the printed form. The funds that report full transparency may provide investors with full position data on either real (or close to real) time basis or on a lagged basis. Most hedge funds regardless of the transparency model usually provide their investors with monthly and quarterly letters.

While the content and quality of these letters differ widely, we found that there are certain commonalities among hedge funds in different strategies. For example, the majority of Equity Long/Short hedge funds report Industry and geographic allocations. Many report concentration and maybe even the names of the top five positions. Fixed Income Arbitrage funds often report their interest rate exposure by currency and maturity buckets.

While a diligent investor may be able to collect many pieces of the available transparency data, the absence of any standards in reporting this data makes it extremely difficult to use it on a consistent basis.

Full Transparency

There have been many calls for requiring hedge funds to provide full transparency. The hedge funds’ rebuttal that those calls are no more legitimate than calls to require Coca Cola to disclose its secret formula is valid in its own right. There is an even stronger argument against full transparency. It will likely do more harm than good for the investor.

Hedge funds invest in a variety of financial instruments that range from plain vanilla stocks and bonds to complex derivative instruments. Most hedge fund investors do not have the necessary systems, budgets, or the time to be able to take every position reported by every hedge fund in their portfolio and perform a meaningful analysis. There are, of course, software solutions that are available on the market that may be able to handle many of the instruments, but the cost and complexity of these solutions in the constrained budget environment may not be justified by the value added.

Obtaining full transparency and failing to analyze it may result in two problems for the investor.

1. After obtaining position data from the fund, the investor may experience a false sense of security and become complacent when analyzing the fund. Full transparency may justify putting a checkmark in a due diligence questionnaire, but may not result in any actionable steps.
2. The second problem may exist for the fund of funds and other professional investors in that failing to perform an adequate analysis of position data may actually imply the failure of fiduciary duties with respect to their clients or share holders.

If full transparency is not appropriate, then the natural question to ask is: What level of transparency should investors demand?

Our View

Transparency reported by hedge fund managers should be reasonable, informative, useful and timely.

Reasonable

To be reasonable, the required transparency should have the following qualities:

1. Reporting frequency should coincide with the fund’s liquidity. While it may be informative to know what the fund with quarterly liquidity is holding on a daily basis, it would not provide investors with any actionable steps, and would impose an undue burden on the manager.
2. Reports produced by the manager should be consistent. An investor should be able to obtain reports in the same format and with the same content.
3. Transparency should not be excessive. Managers should not be required to disclose their trade secrets. Conversely, investors should also be able to process reported information without undue burden and excessive costs.

Informative

Information provided by the fund should be both relevant to the manager’s strategy and comprehensive enough to be able to analyze the fund’s exposure. For Equity Long/Short hedge funds, an investor may want to collect Industry exposures, hedging positions, and top positions. For fixed income funds, an investor needs to collect the interest rate and credit sensitivities (in the form of DV01 and CDV01). Multi strategy funds may need to report a combination of the above.

Useful

There is no point in requesting transparency from hedge funds if the investor makes no use of it. Four types of analysis can be performed using the information collected from hedge funds.

1. Historical Trends. While hedge fund positions may change on a daily or intra-day basis, the overall trend in exposures may provide information about the fund’s style (and potentially about any style drifts).
2. Aggregate Analysis. Being able to collect data in a consistent form would allow investors to aggregate information across hedge funds in their portfolios and get a more complete picture of their investments.
3. Monitoring. Industry exposure and top positions exposures may provide investors with a way to monitor and quickly identify the hedge funds which may be exposed to market news or events.
4. Risk Analysis. Exposure data may be used to perform simulation analysis and estimate such risk analyses as Value at Risk, Drawdown Simulation, and Stress Tests. In the following section we describe the steps necessary for performing such analyses for an equity long/short hedge fund.

Timely

In order for information to be useful and actionable it needs to be delivered on a regular basic and in a timely fashion. Many hedge funds currently file form 13F disclosures that contain information about their long equity holdings. While 13F information may be interesting it’s not timely since it’s delivered quarterly with a lag that may extend up to 45 days. For hedge funds with moderate or high turnover in their portfolios such disclosure proves to be of limited use to investors.

Example:

Risk Analysis – Equity Long/Short Fund

An investor who has collected building blocks for Industry exposures data from an Equity Long/Short hedge fund may use that information to estimate Value At Risk (VaR) using the Monte Carlo techniques. To do that the investor needs to perform the following steps:

* Collect long/short exposure for each Industry
* Make an assumption about correlation between long and short positions
* Simulate results
* Calculate VaR

Collect Long/Short Exposure

Investor can collect information about industry exposure from each Equity Long/Short hedge fund in the portfolio. Exposure information can be mapped into MSCI World or S&P GIC scheme. This would allow investors to assign traded benchmarks to represent each industry exposure. Traded industry indexes or ETFs can be used.

Make an Assumption About Correlation Between Long and Short Positions

An investor must decide whether to use Net or Gross exposure when performing simulations. The decision depends on the relationship between the long and short positions.

For the funds that use short positions as hedges for their long portfolios, net exposure may be an appropriate metric to use since the short positions are assumed to be highly correlated to long positions. For the funds that take directional bet on either long or short side, the gross exposure may be the more appropriate measure.

A more sophisticated model may make an assumption on the actual correlation between long and short positions.

Simulate Results

Historical track records of the proxy ETF, or indexes assigned in Step 1 may be used to estimate the covariance matrix and expected returns. The information then can be used to simulate performance on either a daily, weekly or monthly basis. Different models can be used to perform simulation. In the simplest form, the multi-variate normal distribution may be used to generate return data. Since normal distribution may not be appropriate for capturing tail behavior, different distributions (e.g. student-T, extreme value) may be used to simulate the return data. Copulas may be used to preserve the desired correlation structure.

Once the returns are simulated, Value at Risk as well as other risk statistics can be easily calculated by examining the properties of distribution of the generated returns.

Conclusion

We have presented our views on the appropriate use of hedge fund transparency as well as what level of it should be required from hedge fund managers. While we believe that full transparency should not be required and may actually be detrimental to investors, we support the effort to improve the reporting standards across the hedge fund industry.

Aleksey Matiychenko, CFA, FRM, CAIA, is senior partner and CEO of Risk-AI, LLC. Gregory Dyra is a managing director at New Legacy Capital, LLC.

Hedge funds, which seemed to escape heavy-handed regulation in President Barack Obama’s proposed overhaul last week, may actually be getting more than they bargained for.

Mary Schapiro, chairman of the Securities and Exchange Commission, said the regulator may force hedge funds to disclose stakes in companies held through over-the-counter derivatives. Such a move could make it difficult for funds to quietly acquire large stakes through equity swaps.

“Similar products and activities should be subject to similar regulations and oversight,” Schapiro told a Senate Banking subcommittee today. She added that the “interchangeability of securities and securities-related” derivatives indicates that they should be similarly regulated.

http://www.finalternatives.com/node/8304

Madoff turned the table on the client: he had it set up so that he basically interviewed them for admittance. That made the potential client want it more. I can’t imagine how those people feel right now.

When your money manager is the:

broker/dealer
custodian
investment advisor

you have to have a lot of trust for that person or entity. To me, that type of trust would rank with God or a higher power.

I hold the SEC responsible because they were alerted and they were too afraid to ask for what they needed. Politics has no place in fiduciary care.

So far, nothing has changed since Madoff. There are proposals, but nothing has changed.

Morgan Stanley to offer a trust service called Morgan Stanley Trust National Association that is “a belt-and-suspenders approach” to keeping client assets safe.

Clients have to pay extra. Does anyone know what the terms are? Are the assets commingled? Do you own units of the Trust?

The ex-wife of beleaguered Broadcom Corp. co-founder Henry T. Nicholas III has lost an attempt to limit his control of the family’s fortune.

Orange County Superior Court Judge Mary Fingal Schulte ruled Thursday that probate court was not the proper venue for Stacey Nicholas to seek to have her ex-husband removed as co-trustee of the family’s trust, which she estimated to be worth $600 million.

Attorneys for Henry Nicholas had contended that the action should have been filed in family court, where the couple’s divorce is being heard.

In November, Stacey Nicholas filed a petition in probate court accusing Henry Nicholas of squandering $60 million on misguided investments and personal indulgences, including $1 million she said he spent on private detectives who tailed her, once wearing gorilla masks to conceal their identities. She said his spending had left her so cash poor she couldn’t pay a tax bill.

She also accused Henry Nicholas of threatening to physically harm her, once whispering in her ear that he would have her “whacked.”

Nicholas, in turn, accused his ex-wife of filling her petition with “outrageous falsehoods” in an attempt to damage his reputation.

The couple’s wealth stems from the success of Broadcom, an Irvine-based manufacturer of computer chips used in such products as Apple’s iPhone.

An attorney for Henry Nicholas said Thursday that Judge Schulte’s decision was welcome news.

“It has always been our view that this petition was filed for improper purposes, as a publicity stunt to smear Dr. Nicholas with false accusations,” said attorney Richard Howell, a partner with the Costa Mesa office of Rutan & Tucker. “The court has rejected her petition across the board.”

Robert Sacks, an attorney for Stacey Nicholas, could not be reached.

Henry Nicholas is awaiting criminal prosecution under two federal indictments, one that alleges he provided illegal narcotics to friends and business associates and another that alleges he conspired to backdate stock options as secret rewards to employees without disclosing the arrangement to investors.

Nicholas contends he is innocent of any wrongdoing.