Hedge Fund Due Diligence

The Lancer Funds

I once met a Chinese delegation who wanted to know how we Canadians were doing portfolio management, regulation, etc. I remember an informal discussion with one of the participant where I described our approach to return forecasting, our portfolio construction which integrates risk control – maximizing expected outperformance for a certain risk budget, our performance attribution systems and our market –factor monitoring which gives me insights into what is happening in the market. My interlocutor was puzzled and said “Oh – our approach is much simpler. We buy a stock and then we push the price up.”. I explained that this is not only inappropriate (to be polite, I did not use the word “unethical”) but also illegal in our country…

This action is called “High closing” and can have huge impact when trading smaller cap - less liquid stocks. One should therefore be careful if his manager invests in those illiquid stocks. This is what happened at the Lancer group of funds. So many local investors got caught in this one including University pension plans, city pension plans, and foundations. While various law suits are still ongoing, the owner of the fund was condemned in a civil lawsuit in 2009 for $62 million.

Almost 40% of the $1.1 Billion loss in the Lancer Offshore funds was from Montreal-based investors including University pension plans, city pension plans, and foundations. They had been guided by three key people. The main actor (#1) seems to be out of the circuit. The second (#2) is now advising pension plans on their investments for one of the largest consulting firm. I believe the fund of funds he was managing then had been closed following this huge loss. The third (3) one is marketing hedge funds.

Key person #2 had organized a visit/speech with the Montreal Society of Financial Analyst back in 2001. I remember this meeting as I had met key person #3 there to whom I shared my skepticism. Before the presentation I had asked him about the risk controls in this fund. His answer was “It is great. You will see – it’s different.” I thought there were not many ways to deal with risk. Risk goes down as you take advantage of diversification. The mathematics of estimating the risk of an equity portfolio is straightforward. While detractors keep pointing to some of its imprecision, their alternative is often “no risk measurement” and someone’s feeling or flair…

During the presentation, I felt like attending the speech of a charismatic preacher. Everybody was nodding in acceptance to every word of Michael Lauer. And then one person asked the question I was burning to ask...

“And what about your risk controls?”

His answer was:

“We only buy firms that went down so much – they all have the potential of returning 100% or more.”

And everybody was in agreement and positively nodding with their head!

He did not talk about risk controls at all! That’s when I wrote a big “B.S.” on the paper that was distributed by Michael Lauer . While the B means “Bull”, I was not bullish about this firm… For a copy of the distributed paper with the "B.S." note on it, click here.

When trying to explain why he recommended investing in the Lancer Fund, key person #1 only mentioned “great past returns”. In other word, no due diligence was done besides looking at past performance.

Have any of the investors ever asked for a real performance attribution on this fund? If you do not understand performance attribution, you should not invest in such mandate. Don’t forget that as investors, you get to meet some of the best marketers (preachers). Firms will pay a lot for top marketers who can sell anything to anyone.

Among all investors who lost money in the Lancer Funds, by far the largest group came from Montreal with slightly less than 40% of all assets:

The amount invested before the collapse was, at the end of 2002, close to US $390 M or over CAD $600 Million at the then prevailing exchange rate. It is surprising that all these institutions’ investment committees accepted to invest a large percentage of their assets in a single hedge fund (lack of diversification) and without proper due diligence done.

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Dominic Clermont, ASA, MBA, CFA

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