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Hedge fund style "drift" is
said to occur when a hedge fund manager strays from their stated investment
strategy. The term used to be an esoteric one, used only by professional
hedge fund analysts. However, "drifting" is a problem that is lately coming
into view more by regulators and in litigation by disgruntled investors.
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
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
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.
Read more articles about the hedge fund industry
and related legal issues at Hedge Rows, a blog by Judith Gross
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