Metzger

At the hedge fund course that I teach at Cornell Financial Engineering Manhattan, I stress two things: the need for top-notch internal controls and that operational risk is the great unspoken-about danger.

At a recent meeting of the Committee on Financial Services of the U.S. House of Representatives, I made 10 specific recommendations for new legislation or regulation, among them that there should be separate market-stability and market-integrity regulators and that certain financial institutions should provide complete and timely disclosure of positional information to a market-stability regulator.

Studies of hedge fund failures have concluded that the majority of them folded because of a failure to manage operational risk -- not because of a failed investment strategy.

If investors could be given the tools for evaluating non-financial aspects of investments and could be convinced to use those tools, I am certain that vastly fewer of them would fall prey to investment fraud.

Unfortunately, for many investors, due diligence begins and ends with reviewing the performance record. There is a tendency for investors to "chase returns" and to assume that past performance guarantees future results.

The payoff from many hedge fund strategies is a high probability of a small profit and a low probability of a huge loss. Investment advisers use financial leverage to amplify returns. A manager with an impressive performance record may have achieved that success, not because of his investing skills, but because of his tolerance for risk taking.

Increased transparency allows for better due diligence and monitoring. It can help the investor identify excessive concentrations in her portfolio when she aggregates her investments, and any style drift by the investment adviser.

Eliminating risk taking is impractical because without risk there cannot be any reward. The aim should be to achieve an appropriate balance between risk and return.

Diversification of assets and strategies, which reduces the risk of excessive concentration, is a necessary part of risk management, which must also address low-probability events.

While we may not be able to undo the damage of the past, we should resolve to:

Regulatory reform of the financial services industry should be a high priority.

Leon M. Metzger, a lecturer at Cornell Financial Engineering Manhattan, was formerly vice chairman and chief administrative officer at Paloma Partners Management Co. For the full testimony, see http://www.house.gov/apps/list/hearing/financialsvcs_dem/metzger010509.pdf (pdf).