The dust has hardly settled on the Archegos Capital Management debacle but it’s the latest example of the risk of financial collapse due to the actions of a fund manager.
Just to refresh your memory, Archegos Capital Management (ACM) was a private investment fund that became highly leveraged through the use of derivatives (swaps).
When the market began to move its large position in ViabomCBS, ACM was unable to pay back the banks who had looked past it’s risk profile and allowed the firm to over extend its use of swaps in exchange for fees.
Lenders seized ACM’s assets and began selling them off.
But the appetite for fund investments is not going away and this is backed by the Alternative Investment Allocator Survey conducted by the law firm Seward & Kissel which found that 86% of asset allocations were anticipated to be direct fund investments in 2021.
As family offices and high net worth individuals look to direct more capital towards funds, here are three ways to reduce the risk of fund investments turning sour.
1: Seek reduced or zero leverage
Bill Hwang managed $10 billion through ACM and his main weapon of choice was derivatives.
The public do not actually know the full extent and risk of Hwang’s use of derivatives because the swap deals were made off of exchanges and directly between banks which circumvented the requirement to publicly disclose the derivative positions.
I think this is a classic case of an investor with concentrated positions that have leverage against themDavid Solomon, CEO Goldman Sachs on the Archegos Capital Management collapse
More traditional financial instruments that do not require the use of leverage such as equities and index funds do not attract the same level of risk that off-exchange derivatives contracts do.
If capital allocation is directed towards funds that engage in derivatives contracts deals know that you are increasing the risk of that capital, whether on or off exchange.
2: Demand transparency
Funds that offer separately managed accounts (SMA’s) give investors the highest level of transparency in the fund management industry.
They do this by offering direct ownership of the securities in each account to the individual investor.
You could wake up every morning, log into your individual separately managed account and see a list of all the securities that the fund manager has purchased on your behalf.
At the very least if you see a list of futures contracts when you’ve invested into an index long only fund then you know that something is up.
This distinct feature of SMA’s differs from the more traditional fund structures that typically offer units for sale based on the net asset value of the fund, much like shares of stock in a listed company.
With your separately managed account, you get to peek behind the curtain.
3: Require risk controls
A private fund with a written risk control plan is infinitely better at evidencing that it’s management has at the very least considered the multi-universe of risks associated with running the fund than one that does not have one.
When reviewing the funds documents investors should be on the look out for:
- Trading limits: the degree to which a portfolio is diversified across its portfolio
- Liquidity: how fast can securities be sold at the prevailing market price
- Leverage: how much margin (if any) can a fund use in its trading operations
- Risk governance: a written risk management policy to include acceptable levels of risk, identifying risk exposures and how risks will be mitigated
- Operational risk: continuity and contingency plans that are regularly reviewed
- Risk monitoring: regular checks on all of the above to see if a policy change is needed
The complete elimination of risk is impossible and its important to stress that not all risk controls are appropriate for every fund.
But with a solid and well thought out framework for risk control in place that is fitting for a fund’s investment strategy and size, the safer your fund investment will be.
Proactive due diligence for controlled risk
The fund world has left the the old 2 and 20 opaque model of investment management behind with investments into emerging and start up funds typically offering founder share classes or hurdle rates to entice investors with a reduced risk offering.
Also innovation in digital technologies and fund structures means that investors now have direct access to the investments that are managed on their behalf.
Tap into these innovative fund structures and technologies, your capital will thank you for it.