Madoff Mayhem the Tip of the Iceberg?

Investors sent stocks lower Monday as anxiety over the growing list of firms affected by investment manager Bernard Madoff magnified Wall Street's concerns about the health of the financial sector:

Stocks had traded mixed early on as investors were relieved to hear that President George W. Bush was working on providing short-term government help for the auto industry. The Senate's rejection of a $14 billion bailout for automakers last week had raised the possibility of a major bankruptcy, which some analysts say would result in as many as 3 million U.S. job losses next year.

But as that fear eased somewhat, it gave way to concerns about companies' exposure to Madoff's fund. Well respected in the investment community after serving as chairman of the Nasdaq Stock Market, Madoff was arrested Thursday for orchestrating what prosecutors say was a $50 billion Ponzi scheme to defraud investors.

Firms with exposure include HSBC Holdings PLC, Banco Santander, BNP Paribas, Royal Bank of Scotland Group PLC and hedge fund Man Group PLC. And the list of prominent investors keeps growing.

"This is a massive fraud taking down very intelligent people, very sophisticated investors and it just leaves you a little bit shaky in terms of who's really monitoring the store," said Jay Wong, principal and portfolio manager of Los Angeles-based money manager Payden & Rygel.

The ordeal dealt another blow to investors' confidence in the market, analysts said.

"The investor psyche is already quite fragile. Scandals like this just add fuel to the fire," said Alan Gayle, senior investment strategist for RidgeWorth Capital Management.

Investors also were nervous ahead of earnings reports later this week from the country's two largest investment banks, Goldman Sachs Group Inc. and Morgan Stanley.

Madoff's list of victims reportedly could reach thousands and includes the charities run by Steven Spielberg, Mort Zuckerman, and other non-profit organizations.

Moreover, the Jerusalem Post reports that the Jewish community is bracing for calamity in the wake of the Madoff fraud:

At least $600 million in Jewish charitable funds have been wiped out by the collapse of Bernard Madoff's Wall Street investment firm, a partial review by The Jerusalem Post revealed Monday.

Yet much is still hidden about what may amount to the most spectacular financial disaster to hit Jewish life since the Great Depression, with unconfirmed losses totaling up to $1.5 billion.

Furthermore, the Post's figures do not include billions of dollars lost to individual and family investors, many of whom were the primary donors to Jewish schools, synagogues and communal charities.

So how did Bernie Madoff get away with duping rich investors, sophisticated banks and non-profit organizations?

Clearly the Securities and Exchange Commission dropped the ball. The other part of it was lack of proper due diligence and greed as Madoff had an uncanny ability to charm wealthy investors who fought for a chance to join his "exclusive" club:

In the wealthy enclaves of Long Island and Palm Beach, people spent years trying to get on to Bernie Madoff’s client list. Some even joined the blue-blooded golf clubs where he was a member – and where he recruited many of his investors – just for the chance of meeting him.

Inside this world of predominately older, less flashy investors, there is not just shock and panic over the huge losses inflicted by Mr Madoff’s colossal swindle. There is a profound sense of betrayal. To many he was not just a philanthropic pillar of the community: many considered him a friend.

Mr Madoff’s modus operandi was based on his membership of exclusive clubs in New York and Florida, and on his image as an unimpeachable old-school banker. His company website even praised his personal touch that “harks back to an earlier era in the financial world” and his “unblemished record of value, fair dealing and high ethical standards”.

If you gave your money to Bernie, he would see you right. Nothing flashy, sure, but he was safe and would always get you a steady return. Yet he often turned investors down.

A chance to send your funds to Mr Madoff was so coveted that it was in essence by invitation only. Mr Madoff played golf, often with his wife Ruth, at the Atlantic in the Hamptons, at the venerable Old Oaks in the wealthy Westchester County, New York, and at the Boca Rio in Boca Raton, Florida, an area filled with immensely rich retired people. Some of his wealthiest clients were fellow members of the exclusive Palm Beach Country Club.

In Palm Beach, Florida, many were happy to part with hundreds of thousands of dollars of membership fees each year in the hope of an encounter with Mr Madoff. Roughly a third of the club’s members had invested with him.

He would not even consider taking a client on inside the club without an initial investment of at least $1 million (£654,000).

A warning to high net worth individuals: do not fall for charlatans that are able to schmooze you off your feet and make it look as if you are part of some exclusive club.

I mention the above because a lot of hedge funds were doing the exact same thing in the heyday of hedge fund euphoria.

Pension funds were throwing billions of dollars into "elite" hedge funds and private equity funds with little or no due diligence because they wanted to be "part of the club".

It was mind-boggling to see how easy it was for hedge funds to call their investors and throw them the sales pitch. They would call you up and say "we have some extra capacity for our preferred clients".

And clients would jump at the chance to throw billions into these hedge funds. No questions asked. If so and so opens the door, you take it. It became a competition on who can secure capacity with the top hedge fund players.

Keep in mind that most of these "elite" hedge funds never offered any transparency. You would invest in a fund and they would send you an NAV statement at the end of the month. If you were lucky, some of them would send you a small text which discussed where they made money and their concentrations by sector.

Yeah, the heyday of hedge funds investing where pension funds were basically toppling over each other to be part of the hedge fund beauty contest. Hedge funds spared no expense to woo pension fund managers into investing in their funds and the latter couldn't get enough of the "absolute returns" hedge fund managers were promising them.

I saw it all first hand. It was incredible (and ridiculous). What is even more incredible is that it is still going on today, even after some of the most prominent hedge funds, including D.E Shaw, Farallon and Citadel have frozen redemptions. They are among many hedge funds that closed the gates of hedge hell (few investors paid attention to the redemption clauses!).

Keep in mind that these are fund investments. Most investors do not have a clue about how these funds are being managed on a daily basis. They are not part of a managed account platform where investors have total transparency and total discretion on the underlying portfolio.

I am not suggesting that these hedge funds are perpatrating fraud like Bernie Madoff, but the reality is that they are freezing assets and they offer little or no transparency into their portfolios.

I once invested with a commodity trading advisor (CTA) who was way too volatile for my liking. I asked him to convert our investment from one program (4 x leverage) to a lower volatility program (2 x leverage).

To my dismay, it took him almost three weeks to execute this simple transaction. This fund was investing in the most liquid futures so in theory, it should have been done the day after I sent him a fax. He told me he had problems with his administrator who was withholding the funds. I was pissed off.

I caught another CTA investing part of his cash proceeds into a multi-strategy hedge fund without informing me! Again, I was pissed off and came close to recommending we pull out of both funds.

That is when I realized the futility of fund investments. You can get screwed at any time as hedge funds invest in other hedge funds (like in Madoff's fund) or in illiquid esoteric securities and you are left out in the cold if something goes horribly wrong.

This is why I now advise most institutions to invest in hedge funds (and mutual funds) using managed account platform where you have total transparency and total discretion over the portfolio (you also need to understand the underlying strategies).

Some will argue with me that the best hedge funds will never give you total transparency. So what? Screw them. If enough institutional investors band together and demand transparency, they can use their leverage to get it. If investors can't get their act together, then regulators and lawmakers should demand that institutions investing in hedge funds are required to use managed account platforms.

[Again, keep in mind that managed account platforms are tailored to liquid investments and not all managed accounts offer the same terms and service. If you would like more information on managed accounts, I suggest you contact Innocap , but there are other providers too. I mention them because I consulted for them and was impressed with their direct access platform and service.]

But if you are hell bent on investing in hedge funds via the traditional feeder fund, then make sure you conduct a thorough due diligence on the hedge fund you are considering investing with. If you do not have the proper team to conduct a thorough operational due diligence, then hire experts like Chris Addy at Castle Hall Alternatives or Jim Vos of the hedge fund research and advisory firm Aksia.

Interestingly, Jim Vos was featured on Bloomberg television discussing the red flags in the Madoff case (click on that link to listen to Vos' comments...simply amazing!).

Forensic accountants, former prosecutors and private investigators list some potential red flags at hedge funds that might indicate irregularities and should make investors take notice and probe further:

• Returns that seem too good to be true. Bernard Madoff reported that his portfolio suffered only 5 months of losses out of 156 months. If a fund is reporting spectacular returns at a time most of the industry is suffering, industry experts urged investors to be skeptical and dig below the top line numbers.

• Using law firms, accountants or bankers that are not well-known. Samuel Israel's failed Bayou Group created a fake accountant. Madoff used a small, unknown accountant.

• Sudden delays in getting information: If monthly statements arrive much later than usual or not at all, experts said it is time to ask more questions. Madoff sent his statements by mail not email the way most funds do to let investors make comparisons more easily.

• Rebuffing investors who demand more information. Madoff declined to say much about his strategy telling people who wanted to find out more they were wasting their time.

• Implausible excuses for delays in getting information: If managers say their computer systems have been down for days and they ignore email messages, experts said they would worry.

• Stonewalling requests to visit: This could mean the managers sold off all the office furniture and left behind a receptionist to answer calls.

• A sudden wave of departures: Experts suggest interviewing people who left because they might know if anything unusual is going on.

• A sudden drop in minimum investment requirements, something that happened with Madoff.

• A sudden shift in investment philosophy: If your long/short equity hedge fund suddenly dabbles in commodities and waits weeks to tell you about it, start to worry, the experts said.

• Big unexplained expenses: Question any sharp moves in management fees or other things. It could indicate managers might be funneling money elsewhere, the experts said.

• An inordinate amount of extremely expensive toys: Industry experts said a spending spree on antique Ferraris might be worrying unless the managers are extremely successful and wealthy.

• Building of enormous first or second homes: Industry experts worry the manager might spend more time thinking about drapes than his investment positions.

• Divorce: This could be very messy, industry experts said, adding a breakup could cost the manager a lot of money and emotional energy.

• Inappropriate experience among managers: Check resumes and references carefully, industry experts said warning, for example, that recent college graduates or even economists at Wall Street banks might not have the requisite experience to run a hedge fund.
  

Amazingly, many funds of hedge funds - the so-called experts of hedge funds - failed to pick up on any of these red flags:

Funds of funds were likely to face new questions about their business model, threatening the $685bn they manage, investors and hedge fund managers said.

Hedge funds of funds sell their products in part on their ability to avoid scams in the hedge fund industry, often boasting of due diligence teams that hire private investigators before every investment.

But after some of the biggest funds of funds – Tremont of the US, the RMF division of Man Group of London and Union Bancaire Privée and EIM Group of Switzerland – disclosed that they had bought funds that invested with Madoff, many investors are likely to question the value of such indirect investment.

“This was the train wreck that happened in broad daylight,” said Jim Hedges, a hedge fund adviser, who did not have investors’ money with Mr Madoff. “His alleged strategy didn’t make any sense at all. I went to see him in the 1990s and I have rarely heard such gobbledegook ... he would not even say what his assets under management were.”

Julian Korek, a partner at Kinetic Partners, the hedge fund consultancy, said: “For far too long, people have ignored the operational infrastructure side of due diligence.”

Mr Hedges said that the failure in due diligence on the part of many funds of funds and private banks would have serious repercussions for the industry.

So is Madoff case the last of the major hedge fund fraud cases? Of course not. In fact, it may just shine the light on other hedge funds that have similar unbelievable track records:

Are there others out there? Not that I know of. However, there are certainly hedge funds -- 10,000 lightly regulated investment pools for the ultra rich managing $1.72 trillion -- whose returns are incomprehensible. For example, Renaissance Technologies earns extremely high returns -- its Medallion Fund gained 58% in the first nine months of 2008 -- and its CEO, James Simons, makes billions each year.

But his strategy -- using complex computer-driven mathematical models -- defies explanation.

I am not saying that Renaissance is the next Madoff -- but its steady high performance would make me eager to know how a firm like Aksia would assess it.

[I would also love to know how Renaissance consistently delivers these outstanding results. Yeah, I know they use an army of PhDs in mathematics and physics but something tells me if Einstein were alive, he would be highly skeptical of their returns and remind investors of the theory of gravity and black holes.]

Madoff's bust may not be the final nail in the coffin, but hedge funds will change:

The scandal also raises questions around regulation. While hedge funds are, by definition, less regulated than other vehicles, they still need licences to operate. The US Securities and Exchange Commission granted Mr Madoff approval to conduct his business. The SEC will doubtless now need to answer to US legislators.

"The new financial system we [will] come up with after all this is probably one based on a lot more structured, intrusive and formal structures that mean a lot more regulation," Mr Hahn said.

Some argue that the problem lies with the US model of regulation. The UK's FSA uses principles-based regulation. This, say its advocates, means it evaluates the biggest risks for any particular asset class and more effectively screens businesses applying to operate.

Andrew Shrimpton, a regulatory compliance executive at Kinetic, which provides risk-advisory services to fund managers, said: "It shows how if you have a tick-box approach you miss the elephant in the room.

"The FSA actually have a much better track record at preventing fraud," added Mr Shrimpton, previously the head of Alternative Investments Supervision at the FSA.

Also facing tricky questions are funds-of-funds, which take money from outside investors and place it in an array of hedge funds. They promise to carry out due diligence, so those that got caught out by Madoff, like Man Group's institutional fund of funds business RMF, will doubtless be embarrassed to face their investors.

Despite the issues raised about the industry by their recent predicament, few expect hedge funds to disappear. After all, they have survived previous setbacks such as the 1998 LTCM crisis. And US-based Hedge Fund Research statistics show that while fund closures rose in the first half, there remained a higher number of fund launches.

So will these new funds be different? The short answer is: almost certainly, yes.

One of hedge funds' biggest lures for investors has so far been ease of redemption, and that may need to change. In contrast to private equity, which forces investors to adhere to a lock-in of their investment for the life of a fund, many hedge funds hold contributors in for only a month at a time.

The problem this creates is not just redemptions per se. It is also that redemptions are often out of kilter with investments. A fund taking a three-month bet on a stock, for example, does not want to be forced to sell after one month to return cash to investors.

One way of accommodating all investors is to split the fund, where one part invests in liquid assets and provides investors access to quick redemptions, whereas the other has a longer lock-in period and takes accordingly longer-term bets.

Another intuitive lesson is not to put all your eggs in one basket. Single-strategy hedge funds, those that have focused on a single trick such as M&A-related arbitrage, may have seen their day. As the returns on any single strategy can vary, the need for safety means hedge funds need to broaden their strategies, analysts say.

Funds will also want to revisit the prime broker model of how they interact with banks. Hedge funds have traditionally set up account facilities with banks' prime brokers, which service hedge funds with facilities such as lending shares. But in some instances, banks used the cash for proprietary trading. And in Lehman's case, when the bank went bust, billions of pounds of hedge fund money got locked up.

One solution would be to set up a dedicated account that cannot be traded, from which cash is only released for specific trades ordered by funds. Because banks would not be able to use the money to trade for a profit, the loss of revenue may feed through to fees, making custody a little more costly but a lot less risky.

So while they are facing a difficult time, like any Darwinian case study, hedge funds will survive by evolving.

One thing is for sure, in light of the Madoff case, pension funds need to reassess all their hedge fund investments and ensure that they are taking all necessary measures to mitigate against fraud risk.