Hedge Fund Investors Are Funding Rogue Traders

Nathan Anderson | August 17, 2015

rogue-traderA rogue trader is a trader who risks extreme amounts of firm capital without authorization and then loses it. (Conversely, a rogue trader who MAKES billions is called a “managing director.”) Rogue trading happens when poorly designed incentives are coupled with weak operational controls. Before getting into the risk this presents to your hedge fund investments, let’s review history.

Two-well known examples:

  • Nick Leeson ran the Asia desk at Barings bank. In 1995, he single-handedly lost $1.4b on unauthorized trades and bankrupted the 233 year old institution.
  • Brian Hunter at Amaranth Advisors lost $5b trading weather derivatives.

In the case of Leeson, Barings made him chief trader and compensated him on both profits earned AND made him responsible for reconciling his own trades. (Fox, meet hen house.) In Amaranth’s case, Brian Hunter had a comp structure whereby he made 10% of any profits he made for the firm.

On the surface the Amaranth compensation structure seems like any sales structure; you make a piece of what you earn. So why is this potentially catastrophic for ANY financial firm?

The problem is that a trader risks firm capital to generate upside, but the downside risk is often capped at losing their job. The structure provides a nearly free option; if you put a $5b capital base on the proverbial roulette table and double it, you make a $500m bonus. If you lose it all; you’re temporarily out of a job.

This risk imbalance exists throughout the financial industry. An experiment helps demonstrate this: Let’s say I make a bet with you—I’ll double your money if you beat the S&P 500 next month. If you underperform the index you lose it all. What kind of odds do you give yourself here?

Most normal people will give themselves somewhere around 50% odds to win the bet, and will position their bets accordingly.

Rogue traders, on the other hand, view their odds of winning at almost 100%, and they’re absolutely correct. The reason is that the bet accidentally creates a completely asymmetrical risk/return payoff:

  • You lose if you are down relative to the S&P, whether you’re down 1% or 100%
  • You win if you beat the S&P by any amount, so you can be up by only 1% and win

What this means is that if on ANY DAY of trading you are beating the S&P, you can lock in your gains by selling everything and buying an ETF which tracks the index. If you are down, just dial up the risk slowly (by increasing leverage, using index options, concentrated bets, etc.) until you are ahead, then lock in the gain. Your odds of being ahead of the S&P on an intraday basis at some point during the month and locking in the gain using this strategy are nearly 100%.

The problem, of course, is that you are risking catastrophic long-term losses for comparatively small short-term gains. Eventually you will lose everything with this strategy. Whether it takes 10 months or 10 years is immaterial.

For a rogue trader who benefits only from profit, and will probably suffer a lost job whether he loses 10% or 90% anyway, he has a similar risk/return payoff as the bet above. If he can crank out multi-million dollar bonuses with this strategy for 5 years before he blows up a firm, then it can be personally very lucrative.

The antidote to this scenario is two-fold:

  1. Compensation should be based on risk-adjusted returns, rather than just pure return.
  2. Asset managers should have strict risk limits in place, and segregated risk management duties so that traders are unable to trade beyond their limits.

How to Tell if Your Hedge Fund is Rogue

You may have noticed that the compensation structure at Amaranth (paying traders 10% of profit without regard for risk) is very similar to the standard 20% carried interest that hedge fund managers earn on annual profits. It’s no accident that the fund attrition rate in the hedge fund industry is so high, and investors need to be constantly vigilant against the potential abuses of the industry-standard fee structure.

There are many stories of struggling funds that doubled down on risk when they realized they had nothing to lose because they realize their funds would shut down whether they lost 20% or 40%. In fact, when Amaranth’s natural gas bets went south, they used leverage to double down and try to earn it back.

To protect against the rogue fund manager, investors need a clear understanding of a manager’s incentive structure and enough transparency to know that firms aren’t stepping out of bounds.

One of the best ways to align a manager’s incentives with your own is for a manager to invest a significant portion of his/her own net worth into their fund. Having ‘skin in the game’ tends to put a major damper on excessive risk taking. Otherwise, as Bob Dylan wisely articulated, “when you got nothing, you got nothing to lose.”

Key due-diligence questions:

What percentage of your liquid net worth do you have in the fund?

Are you obligated to inform investors of any meaningful (>10%) withdrawals of your own personal capital from the fund?

Are there any hard position or risk thresholds stated in the fund’s Private Placement Memorandum (PPM)? How do you ensure you are in compliance with those thresholds? How can I as an investor see that you are in compliance with those thresholds?

How much General Partner Capital is in the fund? (Note: You can generally find this in the fund’s audits.)

How to Tell if Your Hedge Fund’s Traders can go Rogue

Aside from the fund structure itself, it is critical to understand the compensation structures of the employee base, and to get a very good grasp on internal risk controls.

Key due-diligence questions to ask:

Who at the firm has discretionary trading authority? How are they compensated?

How do you determine and measure risk limits for traders?

What operational procedures are in place to ensure that those with proprietary trading authority are not taking on too much risk?

How often are trades reviewed?

The bottom line: A good track record of positive returns is nice, but the risk needed to earn those returns is of paramount importance.

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Nathan Anderson

Nate co-founded ClaritySpring and oversees the company's strategy and operations.