Book Review: The Future of Hedge Fund Investing
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Agarwal’s primary focus is funds of funds, the most influential category of intermediaries. His indictment is unwavering and he names names: “Some of the biggest funds of hedge funds in the industry, like … Tremont Capital Management, Ezra Merkin’s Ascot Partners, and Fairfield Greenwich Group completely failed in their fiduciary responsibilities to their investors in conducting appropriate due diligence on Madoff.” He thereby addresses head-on the threshold question that books predating Madoff’s confession, such as Chris Jones’s Hedge Funds of Funds: A Guide for Investors, treat tangentially—whether a fund of funds is providing objective investment advice at all. It is now clear that “funds of funds” encompass two businesses with little in common: objective fund evaluators—real hedge fund analysts and portfolio constructors to whom Jones addressed his thoughtful guidance—and feeder funds, third-party marketers in a barely altered guise. As Agarwal notes, Fairfield Greenwich invested a majority and Tremont “virtually all” of their assets in Madoff, offering their clients not the promised unbiased and rigorous investment analysis, but its polar opposite. They and other feeder funds were often selling little more than entrée to an “exclusive” club many investors found irresistible. (Agarwal’s “Lesson 1: Relationships Do Not Trump Due Diligence.”)
Agarwal exhorts hedge fund investors to demand genuine (not so-called) expertise in their advisors and persuasively concludes that it can be found inside or outside funds of funds. (“Lesson 2: When Investing In Hedge Funds, Hire Experts.”) He decries the dearth of originality and true expertise among the herd of analysts and chief investment officers, supporting his observations with illuminating examples. He overreaches a bit, however, in his confidence in his favored repository of hedge fund expertise—the trader educated at tony schools and forged by the heat of a bulge-bracket prop trading desk. At his most vigorous, Agarwal deems them the “only people who can understand the strategies, how they are constructed and implemented, [and] their pitfalls and challenges.” The investment world is replete with counterexamples; Jim Simons founded Renaissance Technologies after a career in academia—making him, according to Agarwal’s criteria, ill equipped to judge traders and trading strategies. Hedge fund investors might consider instead that evaluating funds requires a mixture of qualitative, quantitative, investment, legal, and other skills obtainable through a multiplicity of gateways and experiences.
Agarwal provides insightful investment advice, cataloging and explaining the major investment strategies hedge funds pursue. He offers a fresh and provocative twist on diversification, arguing that the stodgy subsets of asset class and geography provide limited, if not counterproductive, guideposts. Much more important is whether a fund’s investment thesis depends on “mean reversion,” “positive carry,” “systematic/high frequency trading,” or “momentum.” These differ by anticipated holding period, response to changed market volatility, and other factors that are, Agarwal maintains, more important for an investor to diversify.
Fundamental to successful reform is the interplay between regulators and investor self-help, territory that Agarwal covers adroitly. His advice dovetails neatly with an SEC advisory counseling hedge fund investors to undertake the aggressive information gathering he espouses. He actually understates the benefits of this approach, as private action is generally more beneficial to the investor. Regulatory action—even non-fraud-based—often results in a fund’s end, as in the recent insider trading action against Galleon. The investor able to quietly redeem is better situated than his counterpart ensnared in the liquidation process, with its court filings, uncertain recoveries, attorneys’ fees, and delays.
Anyone thinking of making or managing an investment in a hedge fund should read this timely book, take copious notes, and reread it. They should immediately avail themselves of its advice to retain independent experts and the wisdom of its “Five Inviolable Commandments.” The hedge fund industry has grown exponentially over the past decade, but it is still young and the post-Madoff rethinking is still in its early stage. Agarwal’s work is a commendable first chapter in a story that is only beginning.
–Eric Hansen, CFA, is a principal of Diamond Oak Capital Advisors, LLC, in New York, New York.