Investment Funds: Should You Hear Alarm Bells?
TSF - February 9, 2009

Any one of these nine warning signs alarm the savviest money managers in the world. While nothing may be amiss, these signs should be checked out (See bullett points...more details below):

* A cult figure with no independent third party to verify his claims.

* The fund can hang onto your money.

* No-name banks and accountants.

* Poor transparency.

* No visible risk controls.

* Lots of borrowing.

* A single strategy.

* Unlimited expenses

* Won’t answer questions.


Even Warren Buffett will try to buy an investment fund when the price is right, but it rarely is. He tried to buy Long Term Capital Management (LTCM), a hedge fund that famously blew up in the late 1990’s, but the Federal Reserve Bank, the U.S. central bank, organized a bailout instead. LTCM’s management was honest but unlucky. Lately, we’ve heard a lot about hedge funds and other types of investment funds that have both unlucky and dishonest. The overwhelming majority of these managers are men, because the world of finance is dominated by men. A woman can feel at a disadvantage, but when dealing with the wrong crowd, even savvy male money managers sometimes feel at a disadvantage. How can you tell if you should be worried?

These nine warning signs alarm the savviest money managers in the world:

• A cult figure. If the manager is a cult figure and has no independent third party that verifies his returns, you are probably already in trouble. Do-it-yourself reporting doesn’t cut it when it comes to your money.

• The fund can hang onto your money. This is known as a “gate.” If the fund manager can prevent you from withdrawing your money, or if the fund manager can change the rules later to prevent you from withdrawing your money, you need a very good explanation why this is necessary. (Sometimes there is a legitimate reason for this, such as in a real estate partnership, but it is rare.) If you invested in the stock market, you can get your money anytime you want, even if you have lost money—it is your decision. Yet, money managers with poor performance will tell you that you cannot have your money back and it is for your own good: the fund’s value has taken a beating; if you sell now you will get a lousy price; hang on and things will get better. This may be true, but it is also possible value has been permanently destroyed due to an investment mistake, or worse, the money is missing. In any case it is your money, and you should decide when you get it back and how much of a loss you are willing to take. Do you want to trust the judgment of someone who has just proven he has misjudged the market?

• No-name banks and accountants. It is bad practice if a manager does not separate the investment funds from his other accounts in a custodial account with a well-known bank. He should also have a credible auditor from a large well known accounting firm.

• Poor transparency. It is so hard to tell what you are invested in that your money manager might as well be wearing a flannel nightgown.

• No visible risk controls. If you ask how your manager is controlling the risk and you don’t get an answer you can understand with some proof to go along with it, then your manager probably isn’t managing anything; he’s probably manipulating you.

• Lots of borrowing. In the business this is known as “leverage” or “gearing.” This is just a fancy way of saying I put down only a fraction of the purchase price. If you bought an uninsured car and put 20% down, you don’t want to take it for a spin on New Year’s Eve unless it is armour plated. Most financial assets in this crazy financial environment don’t have that kind of protection, and when you invest in a fund, you don’t have any insurance. In fact you are the insurance. If you have the equivalent of 20% down (5 times leverage), if your car takes more than 20% damage, you are wiped out. Your money disappears faster than a car in Gone in 60 Seconds.

• A single strategy. If your fund’s performance is dominated by one strategy, you should worry. One type of investment strategy does not fit all markets. If you know you are making a bet on say, buying stocks paying high dividends—some of which will have a high chance of being wiped out—go ahead. But don’t pretend it is a long term investment, when it is actually a bet.

• Unlimited expenses. Most funds have a cap on expenses plus management performance fees. Ask your manager where you can find this information in your documents. Do not take his word for it.

• Won’t answer questions. When you are about to give (or if you have given) your money to someone else to manage, any question is a reasonable question. If your manager seems too cocky, patronizes you, or answers your questions with jargon, you are being mistreated. If your manager responds with irritation, anger, or condescension when you ask for clarification, it is a red flag. That said, the most dangerous cat you will ever meet in life is the false leveller, the charming manager who seems to answer your questions, but in reality he is softening you up. He may be charming his way to get into your pockets (instead of your pants). Don’t fall for it.


Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008).

Janet Tavakoli's book on the global financial meltdown is Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley 2009).

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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