Style Drift and Hedge Funds

Style drift is a very important issue for hedge fund managers.  Style drift is basically a change in the hedge fund’s investment strategy from what was defined in the hedge fund’s offering documents.  Normally style drift will start small and get larger.  Some managers will not need to worry about style drift if they’ve crafted a sufficiently broad investment program which allows them to invest in any instruments and without regard to any sort of position limits.

It will be difficult for most investors to detect style drift unless the manager reports its positions as well as its monthly or quarterly profit and losses. However, if a hedge fund manager get sued, one of the first things that the plaintiff’s attorney will do is see if the manager stuck to the investment program as it was laid out in the fund’s offering documents (which includes, if applicable, powerpoints and other marketing materials).  If the hedge fund manager strays from the investment program then the aggrieved investor will have a very good case against the manager.

Some commentators and lawyers believe that we are likely to see investor lawsuits arise as a result of losses from style drift.  These commentators believe that managers may look outside of the stated investment objectives in order to chase returns in this volatile investment environment.  We urge all investment managers to stay within the stated investment objectives and to discuss a potential change with their attorney.

Style drift is an especially important issue for institutional investors, including fund of funds, who have invested in certain hedge funds based on their own asset allocation parameters.  Sometimes institutional investors and fund of funds will request investment level disclosure to monitor this risk – this will normally be laid out in a side letter if the manager does not provide this level of transparency through the offering documents.  Typically the hedge fund prime broker or the administrator can provide position level reporting to the investor.

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