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AlphaMetrix Lawsuit Points To Larger Hedge Fund Risks

AlphaMetrix’s fall from grace points to larger issues the hedge fund industry faces when it comes to the use of non-bank administrators.

“What has been largely missing in the entire discussion of alternative investments is the issue of counterparty integrity,” said Kenneth Phillips, chief executive of HedgeMark International, a BNY Mellon affiliate that provides a managed account infrastructure platform and risk analytics services.

“Who are these financial institutions or, as the case may be, non-bank financial institutions that are providing key services to the fund of which the investor is a beneficiary? Are these non-bank financials capitalized well enough to support the demands that are being made on them?”

AlphaMetrix, which has been sued by the Commodity Futures Trading Commission for allegedly misappropriating $2.8 million, came under severe redemption pressure during a period of a market cycle when its core investment strategies were extremely out of favor, Phillips said. AlphaMetrix was set up as a commodity trading advisor (CTA) platform, but CTA performance has been negative during the quantitative easing period.

Preqin, a data, analysis and intelligence services provider, reported that CTA returns were down 2.5 percent for the year through September, and down 3.8 percent from a year ago. “You can’t give away a CTA today,” Phillips said.

“As AlphaMetrix has come under redemption pressure, their expenses are largely fixed, their revenue variable and therefore eventually something had to give,” he said. “What gave was that they were taking unauthorized loans from the hedge funds they were overseeing.”

The issue here is one of accountability and counterparty integrity, Phillips said, and sophisticated investors have the responsibility of understanding the products they invest in.

A key issue, he said, is establishing who acts as the administrator of a fund? About half of hedge fund assets are administered by bank-affiliated or bank-regulated financial institutions that operate as hedge fund administrators, such as State Street and BNY Mellon. Numerous independent operators also provide fund administration. Phillips said investors should understand the capital adequacy of these non-bank financial institutions “because it’s the responsibility of these administrators to handle the money and report results,” Phillips said.
 
Investors should also understand how the general partner selects prime brokers, or in the case of AlphaMetrix, futures commission merchants. In the traditional assets environment, all purchase and sales transactions are settled back to the custodian daily. In a prime broker structure, they’re settled back to the broker daily.

Hedge fund assets held by prime brokers are typically comingled with other clients and with the regulatory capital of the financial institution, in contrast to traditional assets, which are held in the custodial department of a regulated bank, which cannot comingled assets. This places greater importance on the financial solvency of the prime broker, Phillips said. Investors should understand this, and look closely at the financial solvency of all vendors to the fund in which they’re investing.

Finally, Phillips said, the investor needs to consider the solvency of the fund manager because if the fund comes under enormous financial pressure, as was the case with AlphaMetrix, the fund manager or platform provider has the ability to take money from the fund and route it in a direction other than it was intended to go.

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