Unquantifiable Risk

The hedge fund industry has had no shortage of bad press in the past few years. High fees, high profile flameouts and generally awful returns have been none to kind to the once masters of the finance universe.

This past month has given hedge funds yet another black-eye as well-known and highly respected Visium Asset Management has come under fire for insider trading and was forced to shutter all of their funds. Bloomberg explains:

Jacob Gottlieb’s Visium Asset Management, the once high-flying hedge fund firm that at its peak managed $8 billion, is shutting down four of its remaining hedge funds after one of its star managers was arrested and accused of insider trading.

The New York-based firm will liquidate the main Balanced Fund, as well as its Institutional Partners Fund, Equity Alpha Fund, and Equity Alpha UCITS Fund, according to a letter to investors seen by Bloomberg News. Visium earlier on Friday struck an agreement to sell its multi-sector hedge fund to AllianceBernstein LP.

The decision follows months of turmoil at Visium that began in March when Gottlieb told investors his firm was under federal investigation for some trades. On June 15, U.S. prosecutors said they arrested Sanjay Valvani, a Visium partner and money manager, who the government claims reaped more than $32 million from trades in drug companies using secret tips. Already before the news, clients had asked to pull at least $2 billion from the firm in the second quarter, people familiar with the matter said.

hate to pile on here but I have some personal experience with this fund.  I once sat through an entire sales pitch from Visium. As far as good stories go they checked all of the boxes. Great track record. A well-known investor overseeing the fund. Risk controls galore.

They were fairly unique in the hedge fund space in that they were more of an incubator for other hedge fund managers (similar to Steve Cohen’s firm — who also had an issue with insider trading in the past — or the behemoth Millennium hedge fund run by Izzy Englander). So they would bring in traders or PMs who didn’t want to start their own funds and provide the operational capabilities and allocate capital among the various strategies. The narrative sounded great:

  • Strict net and gross exposure rules for their managers (so they could only go net long or short a certain amount)
  • Very tight loss controls on their managers
  • Were very quick to cut their losers and let go of poor performing managers
  • Invested heavily in people and technology
  • They had a huge group PhDs overseeing their risk management department

On paper and in the sales pitch it sounded like a slam dunk. There were all sorts of brilliant people working for and running the fund. What could possibly go wrong?

For one thing, the extreme competition in the hedge fund industry is a double-edged sword. Insider trading is kind of like professional athletes taking steroids. With that much money at stake is it really that surprising? Visium had an eat-what-you-kill payment structure in terms of performance fees so I can understand why someone would break the rules to try to get ahead. If a manager struggled with their performance they either lost capital or got fired.

I know of a large number of very well-known endowments and foundations who were invested in this fund. These so-called sophisticated institutional investors all have a very strict and detailed due diligence process. They have multiple meetings with the fund managers. They read 200 page prospectuses and legal documents outlining the firm and their strategy. They perform background checks and talk to other investors in the fund.

But you just never know what really goes on in the majority of these funds because there just isn’t much in terms of transparency for investors to go on to really understand the inner-workings of the internal controls and investment processes. I’m guessing very few of the investors in the fund actually understood what they were getting themselves into.

Knowing how these things work, my guess is that it will take a number of months or even years for Visium’s investors to get all of their cash back. Winding down a hedge fund is typically a laborious process because when they’re forced to sell all of their positions that’s when you finally realize how illiquid many of their holdings actually were. And selling $7-8 billion of securities at once could amplify the losses so the unwind will likely be tedious and result in enormous opportunity costs for these investors.

Insider trading could happen outside of the hedge fund complex. But if you’re going to commit fraud, doing so in an illiquid, hard-to-value, opaque fund structure is probably the easiest way to do it.

Institutional investors love to invest in funds with a well-defined and quantifiably risk management system in place. Who wouldn’t? Unfortunately there are certain risks that you just can’t put a number or a formula on. I don’t think enough hedge fund investors appreciate the blow-up risk they take by investing in these types of fund structures. Caveat emptor.

Visium to Shut Four Remaining Hedge Funds as Manager Charged (Bloomberg)

Further Reading:
Why People Invest in Hedge Funds