Hedge Fund Losses Could Lead to Style Drift

Reuters reports on key indexes pointing to large losses by hedge funds in the month of July - and likely for the foreseeable future. The reasons are that many hedge funds that were highly leveraged are receiving margin calls. And a great many firms are being hammered by a combination of falling commodity prices and rising financial stocks, which pressured popular bets in the opposite directions.

As liquidity dries up and prime brokerage lines shrink, we are likely to see more hedge fund managers going outside the box and making riskier, more speculative plays. If these investments diverge from the style or strategy disclosed to investors when they joined the hedge fund, more and more lawsuits based on style drift and fraud (failure to disclose) could be filed by investors.

Investors are entitled to a certain amount of transparacy based on the originally disclosed investment strategy - if the strategy changes, investors should be given an opportunity to either withdraw or consent. Simply baiting and switching is unacceptable and likely will lead to lawsuits. Amarath is viewed as exhibit A. The fund said it was employing a presumably safer multi-strategy approach, but in fact the managers made huge bets in natural gas.

One of the major differences between a claim against a hedge fund and a claim against a brokerage firm is that in many instances the hedge fund investors must file the lawsuit in court instead of through FINRA’s arbitration proceedings. On the surface that is a disadvantage, but given hedge fund managers propensity for secrecy, such a public dispute could lead them to act quickly and make investors whole.

Falcon Falling: Citi’s Hedge Fund Litigation Problem

I’m no expert on public relations, but I’d expect the flacks at Citigroup would go to great lengths to avoid maligning the firm’s Smith Barney brokers. But the financial giant’s public defense for peddling risky proprietary hedge funds to wealthy clients seeking conservative investments implicitly undermines either the integrity or the competency of the firm’s brokers.

“Our disclosures and marketing material sufficiently outlined the inherent risk in the funds and their leveraged strategies,” an unnamed spokesman said in a statement issued to the Wall Street Journal regarding the firm’s Falcon and ASTA/MAT hedge funds, which have lost about 75 percent of their value in the past year.

Oh really? Well if the disclosures were so sufficiently outlined, then how come I’m getting calls from outraged clients who vehemently insist they bought into the hedge funds because they were repeatedly assured by their brokers that the funds were extremely low-risk investments? Smith Barney brokers themselves apparently are even willing to acknowledge that these assurances were given. I quote verbatim here from the Wall Street Journal:

Citigroup brokers and fund managers assured prospective investors that the new hedge funds were low-risk, with Falcon likely to post losses of no more than 5% a year in the worst-case scenario, according to people familiar with the situation.

“That’s why they bought it,” says a Smith Barney broker whose clients, many of them wealthy retirees, invested in the Falcon Funds. “These kinds of clients weren’t looking for a home run.”

Investors rely on the overtures of their brokers, who fashion themselves as financial consultants or advisors, not highly compensated salespeople. “We make money the old-fashioned way. We earn it” – as Smith Barney used to say.

Unfortunately, most brokers don’t have the training or the acumen to understand highly complex and sophisticated financial instruments. So they dutifully rely on the representations given to them by their superiors, who are richly compensated for moving the products out the door.

Herein lies the vicious circle: Citigroup concocts inherently risky funds for its brokers to sell to their wealthy clients that generate handsome fees for the firm and commissions for its brokers. The brokers are told to market the fund as a “conservative” investment, notwithstanding that fact that the funds are so levered that a few ticks the wrong way causes the house-of-cards to collapse. The brokers mimicked the company’s recommended sales pitch to their clients and successfully wrangled hundreds of millions of lucrative assets.

Citigroup, understanding that it has a significant legal liability on its hands, publicly insists that company sufficient disclosed the risks when it marketed the funds. If that was truly the case, the brokers who marketed the funds will deservedly be held legally accountable for failing to educate their clients about the obvious risks.

But more than likely, many of the Smith Barney brokers who marketed the funds themselves were likely led to believe the funds were in fact “low risk.” At a minimum, there was a lack of due diligence. Now that markets are under pressure, Citigroup wants to shift the onus of blame to its brokerage force, rather than hold its wealth management executives accountable. Blaming the folks who followed orders - rather than the ones who gave them - is the way Wall Street works.