Is Your Hedge Fund Style “Drifting”? Quick, Catch It!
Managers that are asked about drifting will usually confidently pull out their offering memo and point to an “investment strategy” section which indicates in extensive legalese that the fund can invest in basically every known security instrument known to the financial world. This language of over-inclusiveness precludes any claim of drifting they will say. ”We are allowed to invest in absolutely everything, so how could we possibly be ‘drifting’? ” That’s how the conventional thinking now goes, but in recent cases and with changes to the advertising landscape yet to come, we believe the reliance on just the offering memo laundry-list language is coming to an end.
In terms of the regulators, in a recent action (SEC v Rooney and Solaris Mgmt), the SEC charged an investment manager with misuse of fund assets for his own benefit. Not a novel situation, but what was different was that the basis for the fraud action rested on the charge that the manager changed the fund’s strategy without disclosure to fund investors. We expect to see more of these types of cases in the future as the SEC gears up to analyze vast quantities of data being mined out of the revised Form ADV and the upcoming Form PF. The Form PF even asks for fairly specific identification of the fund’s strategy (i.e., equity- market neutral, equity- long/short). The SEC has added a Division of Risk, Strategy, and Financial Innovation and within that, Offices of Quantitative Research as well as Risk Assessment and Interactive Data. If style drift is to form the basis of an SEC action in the future, these offices will drive those cases by developing the supporting data for such a claim.
Recent investor litigation has also focused on the issue of style drift. In a recent class action suit filed in early 2012 (Schadv Harbinger Capital Partners LLC), the main claim relates to deviation from
the fund’s stated strategy. Additionally, with marketing materials for hedge funds becoming more sophisticated and widely used (particularly in light of the loosening of advertising restrictions upcoming under the JOBS Act), we expect to see more cases pointing to the stated investment style in the marketing materials, rather than sole reliance on the offering memorandum. For example, if the offering memo states that the fund can invest in absolutely anything, but the marketing materials state that the fund is an emerging markets fund focused on China, a successful claim of style drift might be possible when the manager puts the fund’s portfolio heavily into Iceland.
The case law is evolving in this area, and we will continue to monitor going forward. In the meantime, both investors and managers need to understand the issue and assess their relative positions carefully.