Looking for out-sized performance? Perhaps following the Twitter account of Alexander Alternative Investments will help, and perhaps it won't. The Florida-based firm's account, @OutsizedReturn, will ultimately lead you to the firm's website, where returns promises are whispered into an investor's ear like sweet little nothings. But the tale of Alexander and its founder, Michael Corcelli, might be a cautionary one, highlighting how investors should, at a basic level, learn to identify “yellow” and “red” flag headline due diligence warnings.
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Hedge fund due diligence: Consistent market out-performance, forward-looking promissory statements cause for investigation
“We are highly confident that our energy investments will produced Out-Sized Returns over 50% in 2015,” the website promises, a statement that legal observers find questionable. “We are currently being paid 8.5% dividends while waiting for the value of our investments to appreciate up to 85%,” the site boasts.
What the investment firm fails to mention, however, is perhaps most important. A ValueWalk investigation found that the website makes future promissory returns projections and specifies past returns but doesn’t mention that those returns were not based on actual performance of investor funds. Such modeled performance, even if it uses the fund manager's personal investment capital, is required to be differentiated from actual investor returns in disclosures. (Since confronting Alexander on the issues raised, the website appeared to change in some respects, including deleting the apparent promissory claims referenced above.)
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At the time of ValueWalk’s investigation, the firm claimed at one point to be in the 96th percentile hedge fund ranking based on performance reported to Bloomberg, but these claims could not be corroborated. When asked, Corcelli was unable to provide backup documentation. He may or may not have achieved this status, but the lesson to investors is that if a claim cannot be supported with third party documentation, it might best be questioned.
“Presenting forward-looking guidance that appears substantially higher than industry standards is troubling,” said Braden Perry, a partner with Kennyhertz & Perry, a Kansas City law firm specializing in securities and due diligence legal issues. After reviewing Alexander's original web site, Perry noted several issues.
For an experienced hedge fund watcher, the case of Alexander Alternative Investments may stand out in obtuse fashion. The process of investigating Alexander Alternative Investments highlights how investors might want to consider professional due diligence approaches at even a basic level, even with a fund manager who has been profiled by respected publications such as The Wall Street Journal, Bloomberg News, and Reuters.
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Consistent overstatement of size of returns
In regards to returns, the statistical fact is that investment managers rarely "beat" the market on a consistent, year in year out basis. Whatever the alternative investment, professionals often use an industry benchmark to model the hedge fund performance relative to its beta market environment, or index benchmark. Those hedge funds significantly performing above their “beta market performance driver” should require additional due diligence.
Regardless of the hedge fund benchmark index being used, consistent annual returns in any alternative investment in excess of 25% are sometimes flagged for skeptical investigation – particularly if the returns stream does not correlate to the beta market environment. While hedge funds can and do deliver such over-sized performance, the key is understanding why and how this occurred and if that occurrence is logical and the performance is audited.
For instance, a trend-following hedge fund that consistently claims positive performance during periods of a market environment of price persistence, beating trend-following benchmarks, often warrants further investigation. Certain hedge fund strategies can deliver noncorrelated returns on a consistent basis, a claim that can be validated based on benchmarking the beta marketing environmental measures of performance, but to always win is a feat usually reserved for the likes of Bernie Madoff.
When speaking with ValueWalk, the Corcelli's Alexander fund strategy could not be correlated to a beta market performance driver, which is another flag for potential obfuscation. While returns performance is often the first consideration, it might actually be considered subservient to another review factor.
Registration, independently audited performance are the first questions
Before a conversation considers returns, two questions an investor should ask take priority. First, is the fund manager registered with a regulatory body? And second, are the returns independently audited and available for private inspection?
“Most troubling to me is the fact Alexander is selling investments but is not registered,” Perry said.
The clues to Alexander’s apparent lack of registration stick out like sore thumbs on the website, with the lead clue being a lack of the mandatory risk disclosure on the site and the absence of registration status. Websites selling alternative investments must have a risk disclosure before anyone can enter the site. In many cases, alternative investment websites are restricted to only “qualified participants,” wealthy individuals and professionals, and identification as such is required before accessing any returns or promotional content. For the Alexander website to discuss returns without a regulatory risk disclosure or clear identification of regulatory status is a serious red flag, say those with knowledge of regulatory enforcement guidelines.
Regulatory differences between stocks and derivatives: Meet the SEC & FINRA, and the CFTC & NFA
The regulators for investments in stocks and other securities are the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). If a fund manager uses regulated derivatives, the authorities are the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA). These organizations have best practices and, in the case of the NFA, periodically audit the investment performance and business operations of fund managers selling to general investors. The fund appears to be affiliated with the Florida Alternative Investment Association, but such association with such professional groups is often not as significant as appropriate registration with regulators.
Third-party firms selling investment products are almost always registered, particularly if they are soliciting the general public. Exemptions exist for those selling investments to very wealthy individuals and professional investors, but regardless, all must operate by a similar code of ethical conduct. Perry did say that non-registered consultants to pension funds and institutional investors can make recommendations and evaluate alternative investments for their “qualified” wealthy clients and professional investors.
Individuals who provide consulting services in connection with alternative investments may need to register as an investment adviser with either the SEC or their state regulatory body, Ron Geffner, a partner at Sadis and Goldberg told ValueWalk. A former enforcement attorney with experience practicing regulatory and securities law, Geffner noted that any person who provides investment recommendations or conducts securities analysis in return for a fee, whether through direct management of client assets or via written publications, operates as an investment adviser. In certain circumstances, the need for registration as an investment adviser may hinge on whether there is compensation, or alternatively, the method or type of compensation paid (e.g. commission) may result in other registration requirements (e.g. broker-dealer requirement).
“The threshold question is how is the investment adviser compensated?” he noted, observing that regulators can categorize compensation in terms of non-monetary benefits such as reputation enhancement.
Geffner said the laws and regulations vary by state and regulatory jurisdiction. New York, for instance, has financial regulations which are slightly different from the federal ones, but Florida, where Corcelli is registered, is governed by the SEC and FINRA standards. Generally speaking though, publishers and those delivering investment recommendations to a mass audience, one that is not particularized or tailored to any individual, are exempt from registration as a bona fide publisher. Once a recommendation becomes particularized to a certain group and the consultant is compensated for such services, then the exemption from registration may no longer be available, Geffner advised.
Under SEC guidelines, an investment adviser with over $150 million in assets under management and an individual managing over $100 million in separately managed accounts must be registered. Further, any adviser with over 15 U.S. clients and over $25 million in assets must register.
Alexander, Michael Corcelli fall under FINRA, SEC registration
In a ValueWalk interview, Michael Robert Corcelli, Alexander’s president, fresh off what he said was a marketing campaign looking for new investors, revealed that the fund is not trading client capital, leaving the impression that some performance occurred using his own capital while other performance might have been a modeled back-test. While modeling is an acceptable method to present performance under certain circumstances, it must be done with proper disclosure and consistent testing methodology. Certain regulators do not allow modeled performance and actual performance to be co-mingled in the same presentation table.
Another key for investors is to question unclear or obfuscating answers to direct and simple questions, which at times requires interpretation and understanding of the investment's nuances. Upon vising the Alexander website, one downloads a report that touts the firm’s oil strategy and, again, highlights strong performance. When asked directly whether the fund actually invested in the positions represented on its website, as an Alexander report on the topic implies, Corcelli didn’t directly answer. “It’s clear in the report,” he said. The report indicates actual money was invested in the programs, but the wording was unclear and open for interpretation.
Making forward-looking promissory statements regarding statistically outsized performance can lead to stiff punishment, including disbarment from the financial services industry, assuming the individual is registered. In the interview, Corcelli said he was trading all equity-based products, so if he was registered, it would fall under the SEC and FINRA domain. However, a check of the FINRA Broker Check and NFA online registration systems for securities and derivatives brokers, respectively, reveals that Corcelli currently (as of time of publication) is not registered, although both he and the firm have been registered in the past with both FINRA and the NFA. Just because he is not registered, however, does not mean the firm is out of the reach of the SEC and CFTC, as enforcement action can be taken whenever rules are broken.
Watch for conflated claims of experience and special connections
Consider the old adage that people fortunate enough to have achieved a reasonable degree of success and are well-connected don’t need to talk about it. Now apply this to analysis of an alternative hedge fund investment.
Beyond claims of strong performance, fund managers can at times make over-sized statements that conflate their reputation, but the real size of their experience is smaller than they perceive it to be. This can be one of the easier methods to double check by simply calling the organizations with which the investment manager is associated. Signs of saying something is larger or more potent than it actually is can be commonplace. But if the facts don’t jive with the story, this can be a red flag and, for many institutional investors, a reason to walk out the door before “performance” is even considered.
In the case of Alexander, the firm made claims it was one a major stockholder of The Receivables Exchange, affiliating itself with a prestigious list of Wall Street names that includes Bain Capital, Fidelity Partners and PRISM. When ValueWalk called The Receivables Exchange, however, the firm said “they had never heard of Alexander Alternative Capital.” When confronted with this in an interview, Corcelli claimed a meeting room was named after him, saying it is the responsibility of a firm to know their investors. Corcelli provided a contact, but the exchange official did not return ValueWalk's calls or emails.
Other claims raised similar questions that, rather than leading to answers, led to more questions. Corcelli also claimed to be a partner at Dara Capital AG since January 2014. However, when ValueWalk contacted the firm, Carol O’Donnell, director of legal and compliance at the U.S. division of the firm, said Corcelli has no affiliation with the U.S. division of Dara Capital. She told a ValueWalk researcher that while he might have done some business with the firm’s Swiss entity, he was not a partner in the U.S. Corcelli provided the name of a Swiss executive who might confirm he was a partner at the company, but the contact did not return requests for an email comment by publication time.
Corcelli's claims could be accurate in both instances. However, when an investment adviser provides a referral and that endorser does not return calls or emails, the claims might be best questioned. Other discrepancies in claims should be noted as well. For instance, in his profile, Corcelli claims to have worked at UBS from 2001 to 2005, but based on the FINRA BrokerCheck, he only worked at the firm from 2004 to 2005 and was dismissed for an apparent compliance / marketing violation, sending out letters without approval.
Brokerage firms are required to know their clients
Perhaps the most knowledgeable outside individual regarding a hedge fund’s performance is the brokerage account executive who executes trades. These are people typically with a trading background who enjoy watching a hedge fund strategy being executed. Behind the scenes, brokerage executives are known to respect their hedge fund clients and might occasionally gossip about them as one would a celebrity. The difference is these brokers have direct knowledge of assets under management and asset flows in and out of the fund. Brokerage firms are generally required to “know their customer” to various degrees, and many brokers serving hedge funds actually enjoy tracking performance and getting to know their hedge fund clients.
Due diligence with the brokerage firm can yield interesting results--if they agree to answer questions. It is not uncommon for a brokerage firm to closely monitor the strategy execution of a hedge fund trader, and typically brokerage firms are up front with others in the industry, as any false and misleading statements can land the broker in trouble. This is a point where due diligence can lead to interesting clues, but many brokerage firms are not eager to speak to investors without their client’s approval. Even then, they might walk on eggshells if one doesn't know the revealing questions to ask that provide the broker some protection.
When asked if ValueWalk could ask questions of Corcelli’s listed prime broker, Barclays, Corcelli declined to provide contact information.
Initial steps of due diligence
In this report, several factors of due diligence have been put forward, but true due diligence goes much deeper and is significantly broader. This report, while extensive, is by no means meant to include thorough and complete information on Alexander Alternative Investments and Michael Corcelli. We are simply raising questions for consideration and are not in any way accusing Corcelli or Alexander Alternative Investments of any wrongdoing.
Investors who are interested in conducting their own investigations of any fund or adviser should start the due diligence process on their own by using FINRA’s BrokerCheck, SEC's IAPD, and NFA’s BASIC systems.
[buffett]
The post Hedge Fund Due Diligence Uncovers Serious Questions appeared first on ValueWalk.
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