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Pinpoint why hedge funds have failed in the past.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.a

The idea

Studies of failed hedge funds sort the causes into operational risk, investment risk, business risk and outright fraud. The main lesson is that operational failure is the largest single category, roughly half of cases in the widely cited post-mortems. Operational causes include overstated or manager-controlled valuations, unauthorized trading, misappropriation of assets, misrepresentation to investors and weak controls. Investment causes are excessive leverage, concentration, illiquid positions, style drift away from the stated strategy and an absence of risk limits. Business causes include inadequate capital, failure to scale infrastructure when assets grow, and loss of key people. Poor performance is usually the trigger, with redemptions then exposing weak liquidity and controls. The exam point is that a good track record does not make a fund safe, so due diligence must examine operations as hard as returns.

A practice question

From the question bank, with the reason each wrong option is wrong.

In studies of failed hedge funds, which category is most often identified as the primary cause of failure?

  1. Operational risk, such as misvaluation, unauthorized trading and weak controls - correct
  2. Market risk alone, from adverse moves in the fund's chosen asset classWhy not: Treats failure as purely a market-loss event; post-mortems find operational causes outweigh pure investment losses.
  3. Regulatory risk from new rules restricting hedge fund strategiesWhy not: Confuses an industry-wide regulatory development with the fund-specific causes found in failure studies.
  4. Fee competition that pushed management fees below the cost of running the fundWhy not: Picks a business-model factor that is real but not the dominant cause found in failure studies.

Post-mortems of failed funds find operational failures (misvaluation, unauthorized trading, misappropriation, weak controls) to be the largest single cause, ahead of pure investment losses.

A harder one

A fund with illiquid holdings and quarterly redemption terms loses 12% in a stressed market. Within a month, investors submit redemptions for 35% of assets, and the fund suspends redemptions and then closes. Which statement best describes the lesson from failures like this?

  1. The loss itself was the cause; funds fail only when cumulative losses reach the full value of capitalWhy not: Ignores the redemption and liquidity channel; many funds close well before capital is fully lost.
  2. Poor performance was the trigger, but the failure came from redemptions meeting illiquid assets and weak liquidity management - correct
  3. The failure was an operational failure because redemption processing is an administrator taskWhy not: Confuses the processing of redemptions with the cause of the liquidity shortfall.
  4. The closure shows the manager committed fraud by suspending redemptionsWhy not: Treats a suspension, which the fund documents may permit, as proof of fraud.

Performance usually triggers failure, while the underlying cause is a mismatch between liquidity of assets and of liabilities, often combined with thin capital and weak controls.

The hardest tier

A review of three failed funds found: Fund 1, the manager overrode the administrator's prices on illiquid bonds to hide losses; Fund 2, the sole portfolio manager left with no succession plan and investors redeemed; Fund 3, leverage of eight times NAV produced forced liquidation after a margin call. Which classification of the primary causes is correct?

  1. Fund 1 operational, Fund 2 business, Fund 3 investment - correct
  2. Fund 1 investment risk, Fund 2 operational risk, Fund 3 business riskWhy not: Misreads valuation override as a portfolio decision and key-person loss as a control failure.
  3. Fund 1 business, Fund 2 investment, Fund 3 operationalWhy not: Reverses the categories: leverage is a portfolio decision and key-person loss is a firm-level risk.
  4. Fund 1 operational, Fund 2 investment, Fund 3 businessWhy not: Gets the first right but treats key-person loss as a portfolio risk and leverage as a firm viability issue.

A price override is a valuation control failure (operational). Loss of the only portfolio manager without succession is business risk. Eight times leverage is an investment risk decision.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

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