Hedge Funds: A Fool’s Errand

"Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and brokers’ yachts.’ ‘Where are the customers’ yachts?’ asked the naive visitor."
Fred Schwed Jr.

Was it pure coincidence, or did the federal authorities plan the seizure of Bernie Madoff’s yacht to occur on April Fool’s Day?

Certainly, the more than 6,700 people who have filed claims for some semblance of recovery have spent ample time feeling foolish. But likely, fresh pangs of foolish guilt arose in the guts of those who had the unfortunate displeasure to watch as Madoff’s 55-foot vintage yacht—aptly named “BULL”—was tauntingly ushered away from the pier.

In the 3-1/2 months since the news broke about the biggest ponzi scheme in history, individuals have asserted that they knew Madoff was running a scam. As the dots continue to be connected, it becomes increasingly obvious that the signs were there, the flags were raised, and yet a $50 billion scheme was continually perpetrated on institutions and individuals. The warnings were ignored as people begged Madoff to take their money. When the illusion of a handsome and consistent return was dangled before their eyes, investors gleefully turned a blind eye to some very glaring problems:

Madoff had custody of his firm’s assets
The auditing firm was one man in a strip mall
If you asked for details about the investment strategy, you were not allowed to be a client
Madoff’s alleged consistent returns were said to be generated from equity investments

Madoff sleeps behind bars now, but the story is far from being put to rest.

His sweeping plea/confession has only accelerated the ongoing investigation that now centers on who knew what and when. Evidence is swiftly mounting against the much-talked about “feeder funds” that served as international gateways to Madoff’s scheme. In particular, hedge fund manager Walter Noel of the Fairfield Greenwich Group was slapped with a fraud charge for his part in wiping out $7 billion of his clients' assets in Madoff’s farce.

The charges, inked on April 1, assert that Noel’s firm fooled its investors about the due diligence it conducted with respect to Madoff’s asset management business. The documents describe the profound disparity between the due diligence the Fairfield represented to its clients and what actually transpired. "[We] attempted to discern how Fairfield possibly could not have discovered the fraud during their 18-year relationship [with Madoff]," the Massachusetts Secretary of State said. "The answer, quite simply, is that they were blinded by the fees they were earning, did not engage in meaningful due diligence and turned a blind eye to any fact that would have burst their lucrative bubble," the documents concluded.

Madoff’s vague disclosures and scant accounting methods facilitated the opportunity for backroom deals to victimize unwitting individuals and institutions who relied on what they believed to be “due diligence.”
The promise of due diligence is a shallow one when it is supported by opacity and absent ethical standards.

Index Funds Advisors mostly advises it's clients to invest in mutual funds from Dimensional Fund Advisors (Dimensional or DFA), a highly regarded fund family that is completely transparent.

How is DFA different from Madoff?

Dimensional is regulated under the Investment Company Act of 1940. Madoff ran a hedge fund which was not regulated under the Investment Company Act of 1940. Mutual funds are probably the most highly regulated investment entity in existence.
Clients receive monthly statements and online access to current account information from Schwab or another independent custodian, not Dimensional. Madoff was sending his own statements out.
Schwab, Fidelity, TD Ameritrade or other custodians, are independent of Dimensional Fund Advisors and Index Funds Advisors. When clients make deposits and place trades, that money is handled by Schwab or the other custodians. Dimensional is not the custodian of any client money.
Dimensional uses the largest independent accounting firm in the world, PriceWaterhouseCooper. Their existence relies on the integrity, diligence and accuracy of their reporting. Madoff's accountant, David Friehling, operated as a sole practitioner in a 13-by-18 foot office in Rockland County, New York.
A Net Asset Value (NAV) of each mutual fund is calculated every day. There was no daily NAV calculated for Madoff’s fund. PNC (for domestic) or Citibank (for international) calculates this based off of the actual holdings in the mutual fund entity. Schwab (or any other custodian that receives money from the client) does their due diligence to be sure that the shares of the fund they are holding actually represent interests in a fund that holds the securities.
PNC and Citibank are audited. They are commercial banks and are also highly regulated.
The assets held at DFA's custodian (PNC or Citibank) are separate from the commercial bank assets. If PNC or Citibank were to cease to exist, the funds would still exist, independent of them. The fund entity would just be moved to another custodian.

In regards to IFA, they are a Registered Investment Advisor with the SEC and approved by DFA to offer their funds to individual investors.

IFA provides exclusive online services and resources that educate clients on the principles of investing, including a Risk Capacity™ Survey that matches investors with risk appropriate portfolios. This is achieved by carefully measuring an investor’s Risk Capacity™ and matching it to a Risk Exposure in the form of an index portfolio. An Index Calculator is also provided that can calculate monthly risk and return data of all 20 IFA Index Portfolios and 20 IFA Indexes over the last 81 years. In total, there are about 41,000 monthly returns in the calculator. Lowell Herr of ITA Wealth Management calls ifa.com the "best investment site he has ever seen on the internet."