Spot the Red Flags

There was a crazy story on Bloomberg this morning about an obscure hedge fund that is supposedly putting up some of the best performance numbers in the industry. I say supposedly because the numbers almost have to be false. You couldn’t read this story and come up with any other takeaway.

In many ways, the due diligence process is akin to being a detective or investigative reporter. You always have to dig a little deeper to see what is really going on in terms of the investment process, employees, firm and back office. In this case, you don’t have to dig too far to spot the red flags. They’re all there right at the surface.

Let’s go through the glaring red flags in this fund, its performance figures and the fund structure.

First of all, it’s a black box that purports to only invest in very safe securities:

He says only that he employs a computerized system of his own design but invests most of his clients’ money in safe Treasury bonds.

Next, the fund has used three different auditors in three years:

A lot of things about Arjun might seem peculiar. Since 2013, for instance, it has employed no fewer than three different auditing firms. Brian Kemp, Georgia’s secretary of state, says his securities division has discovered “multiple irregularities” involving Arjun and its parent company, Statim Holdings Inc.

Then the guarantees come into play — never a good sign:

Meyer is so confident in his approach that he offers an extraordinary guarantee: With Arjun, you will never lose money. His price of admission is steep, however. Investors must hand over their cash for a decade. If they exit early, Meyer keeps half the principal.

Also, the fund manager either can’t or won’t explain his investment strategy:

Recknagel says he invested in Arjun after losing confidence in big banks and money-management companies. He concedes he’s not sure how Meyer does what he does.

“I understand it in general, but I probably don’t understand it completely,” Recknagel says.

The custody of assets — the financial institution where they are held — should be a fairly simple part of the investing process. This fund can’t seem to figure out where the asset are being held:

Asked why in a July 12 phone interview, Munshi said the firm mistakenly believed it didn’t have possession, or “custody,” of the assets. In a later interview, he said the firm indeed had custody but thought it could sidestep the rules because of “the method and the way that we had custody through required custodians.”

‘Secret sauce’ and ‘proprietary’:

Meyer says his secret sauce is the proprietary program running on his computer that automatically sends orders to Arjun’s prime broker. He says he tweaks his program every 16 months or so.

Um…

“All it does is look at the last trade and calculate trades that would be equivalent of, ‘What if this security increases 50 percent in value in the next three seconds,”’ Meyer says of his program.

Seriously?

Roberts and Recknagel say they’ve also enjoyed a Statim perk: Meyer extends inexpensive short-term loans against their investments. Recknagel says he’s used the money to invest even more with Meyer. He says he also has a Statim corporate American Express card.

Oh, his wife is writing client communications:

Perks aside, both men say they get scant information about Arjun beyond sporadic investor letters, usually written by Meyer’s wife, Nija. One reviewing Arjun’s 2015 performance said the main share class posted a gain of almost 24 percent that year, when “volatility on an intra-day basis was historical.”

And the kicker — no audited financials to investors:

Since Statim doesn’t send audited financial statements to its investors, they’ll have to take Meyer’s word for it.

To sum up: This fund mostly invests in treasuries using a proprietary computerized trading program that looks for trades that could increase 50% in 3 seconds that is guaranteed to never lose you money in a system his own investors don’t understand and get vague communications about using a fund structure that has shaky audit controls while allowing the fund’s investors to borrow against their own investments only to buy more of those same investments. Oh yeah, and of course the corporate credit card. Gotta earn those points.

Investors are often so blinded by performance track records and intelligent-sounding narratives that they miss any potential red flags that are staring them right in the face. There have been very few fund descriptions that I’ve read about over the years that have more red flags than this one.

This thing has all the makings of a Ponzi Scheme or a fraud.

Source:
How Does This Hedge-Fund Manager Make So Much Money?

Further Reading:
Unquantifiable Risk

 

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