Posted by: jhamon | June 28, 2009

The 7 Habits of Highly Suspicious Hedge Funds

Rick Bookstaber wrote a book I thoroughly enjoyed and highly recommend – A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.

He’s penned a thoughtful post called “The 7 Habits of Highly Suspicious Hedge Funds.”  My subtitle would be, “Why Leverage Is A 4 Letter Word.”  He writes:

 

 

 

 

 

 

 

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.

He goes on to enumerate the 7 Habits.  They are:

  1. No independent risk reporting:  Trust but verify.
  2. A change for the worse in the critical risk numbers:  Have leverage metrics changed?
  3. Increased use of derivatives:  “Derivatives are the weapon of choice for gaming the system.”
  4. High level of secrecy: ‘Nuff said.
  5. Growth in headcount and lifestyle: Has the fund developed an “edifice complex?”
  6. Decline in assets under management: The more assets have declined the more tempting to ratchet up the risk.
  7. Lackluster performance in recent years: the need to get back on top can precipitate desperate acts.

Read the rest here.  

  

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