IN SUMMER 2000, the Art Institute of Chicago fell under the spell of a young hedge fund manager named Conrad Seghers. The allure? Seghers claimed that his funds, called Integral, offered “the highest Sharpe ratios in the industry.” The Sharpe ratio is supposed to measure an investment’s risk relative to its returns and is popular in the world of hedge funds. Convinced by this pitch, the Art Institute committed more than $40 million of its endowment to Seghers’s funds.
A year later, the investments unraveled—and the Art Institute lost 90% of its money.
How can you avoid a similar fate? The simple answer: Avoid private investment funds. Still want to try your hand with a private equity, venture capital or hedge fund? I’d recommend an extra dose of due diligence. As a starting point, ask these 10 questions:
1. Who recommended this investment? The Art Institute thought it was employing best practices by hiring an investment consultant to screen prospective hedge funds. What the folks there overlooked was that the consultant had a financial relationship with Integral and received a hefty matchmaking fee. The lesson: If you’re paying experts for advice, be sure there’s no one else on the other side also paying them.
2. What’s the fee structure? David Swensen, manager of Yale University’s endowment, cautions that, “Investors in hedge funds face dramatically higher levels of prospective failure due to the materially higher level of fees.” As a result, “generating risk-adjusted excess returns [is] nearly an impossible task.” This is not to say that you should never invest in a private investment fund. Indeed, Swensen invests much of Yale’s assets in private funds. But you should think critically about a fund’s ability to overcome its fees and generate healthy performance.
3. What’s behind the fund’s track record? You need to understand how the fund is generating its returns and shouldn’t hesitate to ask questions. If you can’t understand the explanation, don’t invest. Complexity doesn’t necessarily indicate that something is wrong—and, indeed, many perfectly reputable funds pursue highly complex strategies. But if you don’t fully understand the strategy, it means you aren’t in a position to make a determination one way or the other.
4. Does the fund use leverage and, if so, how much? If a fund uses debt, it can amplify your returns, but it also amplifies your risk. A fund’s debt level will give you some indication of how much risk you’re taking—and how badly things could turn out in adverse conditions.
5. Does the fund have a track record through different economic cycles? By the time the Art Institute met Conrad Seghers, he had been in business for just two years. A long track record certainly doesn’t guarantee success—but a limited track record makes it harder to know how your investment might perform.
6. What’s in the fine print? In the end, Seghers was convicted of fraud. Still, Integral’s investor agreements included disclosures that perhaps the Art Institute should have read more carefully. While probably a stretch, Integral’s attorney argued that Seghers “could have bet on the Super Bowl if he wanted.” The lesson: Be sure you understand the fund’s mandate—and that the documents reflect this understanding. Never rely on verbal assurances alone.
7. What do references say? Reputable funds will allow you to speak with both current and former investors. In the case of Seghers’s funds, another investor decided it was “hocus pocus” and pulled his money out before the collapse. I suspect he wasn’t the only one. If you’re looking to make an investment, it’s worth making some calls first.
8. Who are the fund’s vendors? You should always insist that a fund’s assets be held by a well-known independent custodian and you should insist on a national auditing firm. Pick up the phone and verify these relationships independently.
9. Can you estimate the tax impact? To calculate a fund’s after-tax returns, ask for copies of all past annual K-1 forms. At the same time, ask when K-1s are issued. Private funds have a habit of being late with K-1 forms, causing investors to put their own tax returns on extension.
10. What’s the fund’s liquidity policy? Most funds have lock-up policies that limit your ability to withdraw funds on demand. This might prevent you from withdrawing money for some months.
Adam M. Grossman’s previous articles include Don’t Overthink, B Is for Bias and Humble Arithmetic. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.