It was announced recently that a Federal Bankruptcy court judge ordered Bear Stearns, one of America's top tier trading firms to pay $160 million to investors who lost money with a hedge fund that cleared through Bear Stearns. While doing stock research on publicly traded brokerage corporations, we came across the settlement. This spurred us on to thinking, what does this mean for the everyday investor, and what does it mean for stock research in general. Here's the real story.



Hedge Fund's Asset Base SKYROCKETS

Hedge funds have become a significant force in the investment world. At the beginning of the 1990's, hedge funds controlled less than $40 billion in assets, less than Warren Buffett's personal investment portfolio. Today there are more than 9000 hedge funds controlling in excess of $1.1 trillion dollars of assets.

Hedge funds also use leverage, averaging some six times their asset base. This means the industry today controls investments of about $7 trillion dollars. These investments are on both the long and short side. The mutual fund industry can only go long, and never on margin, which means no leverage.

Now leverage is a two-edge sword. When things are going your way, it creates excessive returns or alpha. When trades go against you however, it can wipe out your investment in lightning like fashion. The hedge fund borrows money on its asset base from prime brokers, and other lending institutions. The lender always charges a fee, and the fees are big. For the brokerage firms involved, these fees may make up the vast bulk of their bottom line depending upon the firm involved.

Hedge funds must clear through clearing firms that are referred to as prime brokers. The prime broker sees every trade the hedge fund does, unless the hedge fund employs multiple prime brokers. Now lets say, the hedge fund lays on a massive trade using margin borrowed from the prime broker, and the trade goes against you, meaning paper losses are sustained. What happens next?

The hedge fund has to make a decision as to whether to close out the trade or not. Some funds believing that the momentum will turn, will double down, or increase the investment. The success of this transaction lies in whether or not the momentum is in fact changing at the time of the double down. If not, than the second investment will be under water as well.

Now a prime broker will never allow a hedge fund's trades in total to be under water. This would mean that the hedge fund has gone negative equity, and the prime broker would be at risk. The prime broker never wants to be at risk, nor will it allow itself to be.

Enter the Manhattan Investment Fund

What happened with the fraud we mentioned in the title of this article is that a hedge fund called the Manhattan Investment Fund clearing through Bear Stearns lost nearly $400 million of their assets. These assets belonged to rich investors, and the fund's managers made the wrong bets on Internet stocks in the late 1990's. Apparently Manhattan Investment Fund sought to cover up or delay the inevitable consequences of its trading activities by issuing FALSE reports to its investors.

This led to the creation of an inflated track record, which allowed the hedge fund to bring in even more money, which in turn allowed them to pay off early investors with money from new investors. In other words a classic Ponzi scheme began.

Bear Stearns probably caught onto the scheme when one of its managing directors met an investor in the Manhattan Investment Fund at a party, and the investor talked about how his reports from the hedge fund showed a 20% return. The managing director understood from internal knowledge at the firm that the actual trades going through Bear Stearns were in conflict with what the investor was reporting.

Bear Stearns did follow up with the hedge fund's manager Michael Berger who is now a fugitive at large. Berger got out of the problem by telling Bear Stearns that Bear Stearns was one of only 8 or 9 prime brokers that the hedge fund was doing business with. In other words, we're losing money with you as a prime broker, but not with the other prime brokers we deal with. It's a great story, and even makes sense, but apparently Bear Stearns did not check out the story by calling the other prime brokers to see if it was true that the hedge fund was doing business with them as well.

Somebody at Bear Stearns figured something was amiss because months later, Bear asked the hedge fund to put up additional margin or cash in order to raise the margin requirement to 50% from 35%. The fund sent over another $141 million as margin payments. When the fund went out of business subsequently, Bear Stearns was secure, and did not suffer a loss.

Judge orders Bear Stearns to PAY

The bankruptcy judge controlling this case has ordered Bear Stearns to pay $160 million to the investors in the hedge fund. The judge's ruling stated that Bear Stearns as prime broker, failed to properly supervise the fund's activities prior to the 2000 collapse of the Manhattan Investment Fund.

This ruling is going to be appealed because to allow it to stand would create much greater risk for the prime brokerage industry than the industry feels it is being properly paid to manage. Bear Stearns only made $2.4 million in profits from the hedge fund's activities, and now it is faced with a $160 million judgment.

What you the Investor need to know ? Diversification?

If you are an investor in hedge funds, what you need to know is that any hedge fund can go belly up. That's right, any of them. You cannot outthink someone who while running a hedge fund, is trying to defraud you. The only answer is DIVERSIFICATION in your personal investment structure. You must own an assortment of hedge funds if that is your investment vehicle choice, and not just one. Your funds should also use different investment strategies, and not just be equities long, or domestic, or any other classification.

Since you are searching for the elusive alpha (outsize returns), it your responsibility as an investor to be aware that fraud exists. Even just plain bad investment strategies can result in the loss of all your capital since these funds are using 6 to 1 leverage in the attempt to create performance.

You might also want to consider a FUND OF FUNDS vehicle. This is when you invest your money with a fund manager who makes no direct investments himself, but instead selects other hedge funds for you to be invested in. This involves a double layering of fees. If the returns are there for you year after year, than it doesn't matter, but be careful, fraud does exist, and so do poor investment managers.

Goodbye and Good Luck