Whether you are an investor looking at investing in a hedge fund, or you are interested in starting your own hedge fund, you will find this article to be extremely useful.
For interested hedge fund investors, this will help you detect and identify potentially unreliable, or even worse, fraudulent, fund managers and save you a lot of time and money.
For upcoming hedge fund managers, this will help you attract high-caliber professional and institutional investors, as well as add credibility to your investment management business as a whole.
Crucial components of a good hedge fund track record
1. Verified by credible, independent third-party accountants and auditors
First and foremost, the hedge fund's track record report must be verified by credible and independent professionals (accountants and auditors) from countries with strict professional code of conduct and well-established financial systems.
Bad examples
(1) Trading platform & brokerage statements: these statements have very minimal or no value at all - they might as well be edited/photoshopped by the trader; if not, they could also be from demo/paper trading accounts (which have no indication of the trader's live/real money trading performance);
(2) Low cost online third-party verification: typically, these are automated websites that connect to various trading platforms. The data is still easy to manipulate. Furthermore, even though some trading performance data is accurate on these websites, there's survivorship bias—when some traders ONLY upload successful trading results and simply remove the bad ones;
(3) Accountant/Auditor's reports that do not perform any verification of source documents: for example, a compilation report - unlike a review or an audit, a compilation report provides no assurance. With the accountant/auditor making no effort to test the information being provided by the trader/fund manager, a compilation report does not provide much value to the intended users.
Good examples
Investment managers can manage their users’ need to receive a historical performance track record in several ways. The most straight-forward way to do this is to prepare a summary of the investment manager’s historical performance verified by an independent accountant. (Source: KPMG)
(1) Accountant reports from countries with strict professional codes of conduct and well-established financial systems: generally, most trustworthy reports are from professionals based in the US, UK, Germany, and Australia. Reports from well-established offshore/mid-shore financial centers can also be trusted (i.e., Cayman Islands, BVI, Hong Kong, Switzerland, etc.).
These reports are much more reliable because they are easier to verify. Potential investors can contact the writer directly to double check its legitimacy. The person & entity behind the letter can also be checked for credibility.
CPA/CA that is not registered should not be trusted. Legitimate professionals will always put their name, title, and sometimes their professional registration number behind their reports if they are confident.**
Accountant reports are simple, straightforward yet cost-effective, making them perfect for newer fund managers trying to build a name for themselves. However, once the hedge fund grows bigger, fund managers should add the auditor's reports on top of the accountant's reports. Yes, it is going to be more time-consuming and costly, but it will be absolutely worth it in the long run.
(2) Independent Auditor's review or audit reports: this takes the reliability of the fund manager's track record to the next level. Unlike a compilation report, in a review or audit engagement, the independent auditor actually performs analytical procedures and verifies the source documents of the fund's trading history, therefore, the auditor's report gives assurance to the intended users (i.e. potential investors) that the information and numbers are "true and fair".
Just like CPA reports, almost all legitimate auditors will put their name, title, and sometimes auditor registration number behind their reports. Potential investors can certainly always call the auditor and/or the audit & assurance firm to double check the authenticity of the report.
2. Fund structure, fund size (NAV) and Assets Under Management (AUM) do matter
Another very important factor to consider is the experience of the hedge fund and the portfolio manager.
Fund structure: generally, track records from personal trading accounts will not and should not be taken seriously. As we mentioned above about the survivorship bias - an individual trader could potentially have multiple different trading accounts running, and only get the ones with the best results certified/audited.
On the other hand, a properly structured fund (LP/GP, LLC, IBC, Corp.) with numerous partners & investors, a sizable Net Asset Value (bear minimum $50m+) and most importantly, consistent track records & reporting from the beginning, is much more trustworthy.
Fund size and the company's AUM: this one is very straight-forward. Generally, the more established a hedge fund is, the bigger the AUM, and consequently, the more it has to lose if things go south - both financially and reputationally. Sure, out of the 15000 hedge funds in the world, there were a handful of high-profile failures here and there when funds with hundreds of millions, or even billions of dollars under management blew up, but statistically speaking, it's still extremely rare. In most cases, the bigger the fund grows, the more important risk management becomes for the manager and the fund.
On the other side of the spectrum, it is absolutely possible for a trader who's only traded his/her own account to lose 90% of its equity, move onto the new strategy, and start all over again. Additionally, a trader's ability to generate a 10% return on $100k does not translate into his/her ability to generate a 10% return on $50 million.
3. At least 1 year of track record, preferably covering both bull & bear markets
Ideally, a hedge fund should have track records from both bull and bear markets, covering at least 1 year. A sudden and vicious bear market is the true test of a hedge fund's risk management strategy.
A prime example: the most recent bear market happened during the February - March 2020 crash in global stock markets due to COVID-19 outbreak. Below is the chart of the S&P 500. The index went from its all time high of 3394 (on Feb 20), to a multi-year low of 2200 (on March 23) in a month, the fastest 35% crash ever.
The speed and magnitude of the crash caught many hedge fund managers off-guard, and some of them had to shut down their businesses for good due to the severe losses they suffered.
Conclusion
In conclusion, a good hedge fund track record should at least have:
Reports issued by credible & independent third party accountants and auditors;
The fund is properly structured (i.e. LP/GP, IBC, Corp.) with numerous limited partners/shareholders, sizable Net Asset Value (NAV) and most importantly, consistent track records & reporting from the beginning;
At least 1 year of track record, preferably covering both bull & bear markets.
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