Assessing investment risk should be bread and butter to investment professionals but as recent dramatic news stories show, they can often get it badly wrong.

Assessing investment risk should be bread and butter to investment professionals but as recent dramatic news stories show, they can often get it badly wrong. They use sophisticated models to contain the unexpected but in the heady haze of the credit bubble many forgot the wisdom of Warren Buffett’s famous observation that “it’s only when the tide goes out that you learn who is swimming naked”.

How many now regret not looking below the surface and making that assessment before the tide turned? Within the last year, we’ve all fallen victim to this financial skinny dipping.

The biggest example by far is Bernard Madoff’s alleged Ponzi scheme. Rather than participating in the complex trades his clients imagined, he is alleged to have simply put investors’ cash aside to fund other investors’ redemptions.

With Mr Madoff’s own company providing all essential services to his investment funds, and a tiny firm of accountants checking the books (reports suggest the firm only employed one active auditor), a fraud would be easy enough to disguise. Prosecutors suggest that as investors retreated from risk and demanded redemptions that Mr Madoff could not honour, he confessed to the scam.

But apart from the danger of fraud when an investment fund has no segregation of duty, 2008 exposed other problems connected with relying too heavily on one institution.

The prime broker model widely used by hedge funds offers the funds trading desk simple and easy access to credit lines, stock lending, cash management, brokerage, settlement and custody facilities. With one phone call, the hedge fund trader can borrow cash to buy long, place the trade and know it will settle to his custody account. In the same call, he can borrow stock and sell it short. He can then concentrate on his next trade because effectively, all back office operations, banking and brokerage facilities are taken care of by the prime broker.

The system was an unquestioned success for years because the investment banking institutions dominating the sector were robust. They were supported by the sheer complexity of their tangled web of trades and deemed simply too big to fail. That, of course, was before the banking crisis of last year proved that even Lehman Brothers had an Achilles heel.

For the hedge fund managers who used Lehman, the firm’s bankruptcy was a disaster. For example, US-based Oak Group lost the full $25 million invested in its hedge funds since it used Lehman as it sole prime broker.

German investors holding ‘zertifikates’ lost-out too. This structured product is similar to a bearer bond where the issuing company, in this case Lehman Brothers, owns the underlying investments. The investment allowed holders to participate in share rises up to a certain level, but protected them from downside risk. As such, it was marketed to particularly cautious investors. Lehman’s high credit rating, right up to the point where it fell, falsely reassured investors and the advisers distributing the product of the security of the investment. When Lehman Brothers collapsed, the zertificate holders were left with nothing but a place towards the bottom of the list of Lehman creditors.

The mutual fund may not appear as cutting edge or exciting as a free, flexible and agile hedge fund, but it is precisely for this reason that many investors will warm to them. I think a key selling point of mutual funds in 2009, particularly any that fall under
Europe’s UCITS III rules, will be their transparency, simple structure and the tight regulation they are subject to.

Fundamental to the construction of a UCITS fund is the requirement for the assets to be held by a custodian which is independent of the fund manager, and for the distributing company (which holds the clients’ assets in nominee name) to be separate from the fund management firm. Clients’ assets are ring-fenced with the aim of offering protection from failure or fraud at trading counterparties, the fund manager or custodian.

The simplicity of ownership and liability in a UCITS III fund will also appeal to investors who are worried about corporate failure. A UCITS III investor owns shares in a fund; their investment is worth the value of the shares. This is in contrast to other investment structures where the investor owns a paper entitlement rather than real assets.

In any environment, investors should perform due diligence thoroughly and ensure they invest with asset managers who do theirs. They should look for the managers who do their own open and independent assessments of counterparties. They should understand who is responsible for what; who owns what and what risks are involved, even in the worst, worst case scenario.