Most know that the International Monetary Fund isn’t a bank in the conventional sense – at least in theory, or in the way those who frequent these virtual pages think of them.

Yet headlines and anecdotal evidence over the past few weeks might suggest there is more bank – and even fund-like activity – going on than meets the eye.

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With the explosion of hunters searching for the same scarce alpha and the proliferation of high-frequency trading, is asset management still all about alpha?  Yes, says Jane Li, CAIA, of  FundQuest, a division of BNP Paribas.  Her research of over 10,000 mutual funds (both alive and dead) collectively managing $4  trillion shows that it depends on which category of fund you’re talking about.

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Right up until last fall, practically every alternative investment conference this side of the date line had at least one panel of experts discussing and debating the elusive search for alpha, and how to capture and augment a traditional or even non-traditional portfolio by finding managers that were truly capable of generating non-beta returns.

And then the black swan-poop hit the fan.

Nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished. It’s more about earning a return – period – than earning a return above and beyond what the rest of the market is looking for.

Along these new lines has emerged a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.

From market-timing and late-trading to illiquid valuation techniques and 20:1 levered bets to discrepancies in share pricings between markets and indices to the growing popularity of super low-latency flash trading, these pundits, who wish to remain both nameless and faceless for fear of being drawn and quartered by their bretheren, argue that alpha can’t be obtained legally.

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Does regulation prevent fraud?  Who knows?  But according to this colorful and detailed account of one famous case, the SEC should think again if it expects to stamp out fraud using new regulatory powers.  The case is Manhattan Capital and the chronicler is Chidem Kurdas, one of the world’s most experienced and articulate hedge fund journalists.  Kurdas’ account of the Manhattan case in the Winter 2009 edition of The Independent Review is well worth the read – particularly as we move into an era of greater hedge fund oversight.

Kurdas points out that “regulatory frenzy occurs every time another fiasco occurs.” And when it does, it’s often ineffective unless an interested party complains after the fact – that is, when the damage is done.”

Kurdas says that “at least one aspect of the Manhattan Fund vividly demonstrates regulations failure to deter fraud.” But it’s clear that this case study (written before the Madoff Affair) may provide some important lessons.  In a nutshell, here’s what happened…

Michael Berger, described by Kurdas in this blog post as a “restless” 22 year old Austrian immigrant, launched Manhattan in 1996 with a decidedly bearish view of equities.  According to Kurdas’ account, he raised $600 million over 4 years from investors who, like him, wanted to take out a sort of “insurance” against a market downturn.  The problem, of course, was that this market downturn didn’t come soon enough for Berger and his investors.

Although Manhattan was later described as a Ponzi scheme, Kurda’s explains that it was actually a “real investment operation”. But as losses mounted, Berger began to cook the books by submitting fake holdings data to his administrator.  That administrator trusted Berger’s data since it purportedly came directly from the fund’s introducing broker – a small Ohio firm that in turn used Bear Stearns as its prime broker.

The problem was, Manhattan accounted for a significant portion of the introducing broker’s revenue – leading some to believe that it was too quick to acquiesce to Berger’s demands.  One of the those demands was

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Granted, it took a future Nobel Laureate to invent the Sharpe ratio.  Yet this handy measure has achieved unprecedented ubiquity largely because of its simplicity and ease of use, not necessarily its robustness.

The Sharpe ratio assumes that returns are symmetrical and bell-shaped – that the chance of winning is the same as the chance of losing and that these chances are easily predictable if you know the standard deviation.  But since hedge funds tend to invest in things that have asymmetrical returns (options, for example), their own returns are often skewed to the positive or negative.  Furthermore, these exotic instruments tend to increase the chances of both winning and losing even though the standard deviation of the fund may not change at all.

Given this, you’d think that better measures of hedge fund performance exist somewhere out there.  In fact, we’ve written about several candidates on these pages.  But a study by Martin Eling of the University of St. Gallen and Frank Schuhmacher of the University of Applied Sciences and Technology Aachen suggests that such a search might actually be in vain.  In fact, the duo say the choice of performance measure doesn’t actually influence the relative ranking of hedge funds much at all.  (They extend their research into the world of mutual funds in the May/June 2008 issue of the Financial Analysts Journal.)

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There are few products in the world with as many confusing and contradictory marketing constraints as hedge funds in the US (and, in fairness, many other jurisdictions).  Hedge fund marketers out there know what I’m talking about.  Last month, we told you about a study that compared hedge fund regulatory regimes around the world to see if the lax ones were more popular.  Despite carrying the mantle of the free market, the US actually had a very restrictive regime when compared to countries such as Australia, Canada, Japan, and even China.

An article in this month’s Journal of Financial Transformation illustrates why this is.  The piece, titled ”Hedge fund marketing in an era of regulatory uncertainty” covers many of the issues faced by those trying to raise money in the US.  It’s a great update on the ebb and flow of SEC edicts over the past year and was co-authored by hedge fund personality James Hedges.

The article describes Congress’ response to the SE having the rug pulled out from under them on hedge fund registration back in 2004.  Sensing an opportunity after manager Phil Goldstein successfully challenged the SEC’s registration rule, Congress stepped into create a “legislative override”.  While leaving the registration issue in Congress’ capable hands, the SEC embarked on an anti-fraud rule that makes it illegal to break the law (see related posting).

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You have to give regulators an “A” for effort.  We’re not totally anti-regulation here at AllAboutAlpha.com.  But we do find in curious how most, if not all, attempts to regulate hedge funds seem to have eventually come to a crashing halt.

The SEC set the example with its attempt to make hedge fund register back in 2006.  Now the California Department of Corporations’ attempt to register hedge funds seems to have also met an untimely demise.  HedgeWorld chronicles the whole sorry affair in detail…

As HedgeWorld points out, the proposed regulation would have required all funds not already voluntarily registered with the SEC to register with the Golden State.  But to its surprise, the government of California found out that hedge funds would just leave the state to avoid the hassle (who could have known, really…).

In what appears to be a move to save face, California government officials said that “in light of the ongoing actions of federal regulators”, they would hold off on any further action on the regulatory front.  Apparently, new regulations were “premature”. (Indeed, the time to drive hedge funds out of your state is later, not now).

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News of the latest regulatory scrutiny for hedge funds began circulating earlier this week and yesterday made the pages of InstitutionalInvestor.com.  The Ontario Securities Commission (OSC), Canada’s de facto securities regulator, released a review of the sales practices of “non-prospectused” (non-mutual fund) funds in that province.  Although only about 1 in 20 AllAboutAlpha.com readers are inhabitants of that locale, what the OSC has to say will resonate with anyone in the hedge fund business from Sydney to Zurich to San Francisco.

First, A sober second thought…

Headlines such as “Hedge funds marketing gets failing grade” and “HFs Mislead in Mysterious Ways“, “Securities regulator tightening up on marketing practices of hedge funds” are unfortunate and misleading since the OSC’s review was actually conducted not on hedge funds per se, but on “portfolio managers of non-prospectus qualified investment funds…that catered to large institutional investors and…a variety of clients, including private clients.”

The subsequent recommendations suggests that many of these were traditional institutional managers and wealth manager who managed traditional private client accounts.  (The OSC provided its “suggestions” only and did not actually “tighten” up any practices.)

It appears as if one major Canadian newspaper may have even back-peddled a little on the hedge fund finger-pointing.  It’s online story on November 9th was apparently originally titled “Hedge fund marketing gets failing grade” (click here for screen shot of Google cached image from 6:30pm GMT November 9), but was quickly broadened to “Money Managers’ marketing gets failing grade” (click here for screen shot taken at 3pm GMT November 15).

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In a previous life, Alpha Male was a director at a business strategy think tank that researched, amongst other things, transparency.  Only this “transparency” was the sort demanded by social activists and other stakeholders of global corporations, not the oft-cited position transparency we all love (or hate) in the hedge fund business.

Still, much of the lessons learned in the course of our research applies to transparency in fund management as well.  This is what the Wall Street Journal had to say about a book written upon completion of the research:

“An old force with new power is triggering profound changes across the corporate world. Those who harness its power will thrive; those who ignore it risk paying a high price.

The force is transparency.  This is far more than the obligation to disclose financial data. People and institutions that interact with firms are gaining unprecedented access to all sorts of information about corporate behavior, operations and performance…The corporation is becoming naked.”

Well “nakedness” seems to be revealing itself again.  The perennial issue of hedge fund transparency is streaking onto the industry’s agenda right now.

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Heard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today…

“His trading process may be “naive”, but his fees sure aren’t!”

- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm.

“The asset information submitted to any of the databases is absolutely useless.  How many of the biggest hedge funds in the world actually provide an information to any database?  BGI, one of the world’s largest hedge fund managers, does not submit its data to any of the hedge fund indexes.”

“Five years from now, all hedge fund replicators will be out of business.  We’ll all look back and think ‘what a silly idea that was’!”

- Stan Beckers, Head of Alpha Management, BGI on hedge fund databases and hedge fund cloning in general

“Tom Schneeweis and I published our own hedge fund replication results on our website 6 years ago.  But we only got 2 phone calls…No one cared…so eventually we stopped doing it.  Apparently we should have continued.”

- Hossein Kazemi, Center for International Securities and Derivatives Markets (CISDM), jokes about his sense of timing in front of an overflow conference audience

Click below for more quotes from the lakeside…

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As many readers will know, the US Securities and Exchange Commission passed a new “hedge fund” anti-fraud rule on July 11.  We have poked fun of it a few times – including in the most recent edition of our “Alpha Mail” email update – because of its apparent redundancy.  It seems to simply confirm that it remains illegal to break the law.

(If you’re an asset manager and the mere thought of reading another story about hedge fund regulation makes your toes curl, we recommend you forward this posting to your compliance officer.  We think it’s definitely worthwhile having someone at your organization check this out.)

Although the rule applies equally to mutual funds, private equity funds and hedge funds (any pooled investment vehicle), the media has emphasized the hedge fund angle with statements like:

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Alpha-centric investing refers to more than just portable alpha. As we have reported on this blog, it encapsulates new operational infrastructures (UMAs), new fee arrangements (performance fees with benchmark hurdles / fee-per-alpha), new metrics (ranking funds based on alpha instead of absolute returns), new organizational structures (small teams of alpha producers), and new advisory models (fee-based vs. commission-based). A recent investment newsletter highlights another domain that is impacted by this simple idea: regulation.

In his January 26th weekly newsletter Accredited Investor author John Mauldin covers the SEC’s proposed new hedge fund investment eligibility rules (which, as an aside, come attached to new anti-fraud provisions that confirm it is still illegal to break the law).

Background

Currently the minimum total net worth required to invest in private offerings such as hedge funds in the United States is $1 million.  (Spent everything but still have a great job?  No worries as long as your income is (individually) $200,000 or (with spouse) $300,000).  Collectively, these individuals are known as accredited investors.

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By: Sebastian Mallaby, Foreign Affairs
Published: January/February 2007

In this comprehensive defense of the hedge fund industry, Washington Post columnist Sebastian Mallaby echoes a theme that has weaved its way through stories several times on this blog: the parallels between technological innovation and financial innovation, between e-business start-ups and hedge fund start-ups, and between economic efficiencies resulting from process disintermediation and financial efficiencies resulting from the disintermediation of securities (such as mutual funds).

Writes Mallaby:

“Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.

“Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world’s capital to the companies, industries, and countries that can use it most productively.”

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