Recent Hedge Fund Losses Could Lead to Style Drift

by: Jake Zamansky

Reuters reports on key indexes pointing to large losses by hedge funds in the month of July - and likely for the foreseeable future. The reasons?  Many hedge funds that were highly leveraged are receiving margin calls. And a great many firms are being hammered by a combination of falling commodity prices and rising financial stocks, which pressured popular bets in the opposite directions.

As liquidity dries up and prime brokerage lines shrink, we are likely to see more hedge fund managers going outside the box and making riskier, more speculative plays. If these investments diverge from the style or strategy disclosed to investors when they joined the hedge fund, more and more lawsuits based on style drift and fraud (failure to disclose) could be filed by investors.

Investors are entitled to a certain amount of transparacy based on the originally disclosed investment strategy - if the strategy changes, investors should be given an opportunity to either withdraw or consent. Simply baiting and switching is unacceptable and likely will lead to lawsuits. Amarath is viewed as exhibit A. The fund said it was employing a presumably safer multi-strategy approach, but in fact the managers made huge bets in natural gas.

One of the major differences between a claim against a hedge fund and a claim against a brokerage firm is that in many instances the hedge fund investors must file the lawsuit in court instead of through FINRA’s arbitration proceedings. On the surface that is a disadvantage, but given hedge fund managers propensity for secrecy, such a public dispute could lead them to act quickly and make investors whole.