Last One In Has a Rotten Nest Egg

Hedge fund investors are likely waiting for the other shoe to drop as fresh news reveals a massive—nearly incomprehensible—hedge fund Ponzi scheme with estimated losses of a whopping $50 billion (yes, that is billion with a B) losses.

Early details reveal that the (until now) highly regarded former chairman of the NASDAQ Stock Exchange and a Wall Street veteran of more than 50 years was turned in by his sons for running a fraudulent fund of funds hedge fund that bilked other hedge funds out of billions.

Bernie Madoff confessed his long-running deception which involved reporting stellar, but fictitious earnings. When confronted by a special agent from the FBI who asked if there was an innocent explanation, Madoff replied, “There is no innocent explanation.” According to the indictment, Madoff conceded that it was all his fault and that he “paid investors with money that wasn’t there.”

The Ponzi scheme originated as Madoff invested and lost investors’ money. Instead of being honest about the bad returns, Madoff pumped up returns so new investors would want in. In doing so, he kept the deception going. If liquidations were requested, they were paid out using the investment contributions of later investors. The fund of funds hedge fund ran aground as hedge fund managers requested liquidations amounting to $7 billion to cover the liquidation requests from their own funds and there was no way to pay. Madoff’s hedge fund had a mere $200-$300 million in the coffers and not enough assets to sell to drum up that kind of cash.

Backed against the wall, Madoff came clean only after he had cleaned out his clients and “Madoff” with the money—attempting to pay out bonuses to select employees with the last of the remaining money. According to the indictment, witness statements express that Madoff intended to turn himself in once the last of the money had been dispersed in accordance with his master plan.  

The indictment states that Madoff made use of his highly-esteemed reputation as a “leading international market-maker” to foster confidence among investors. His website offers the image of a company built by a man of both experience and integrity. It states, “The firm has been providing quality executions for broker-dealers, banks and financial institutions since its inception in 1960.”

Madoff’s deception was fueled by his ability to leverage his time served as a key and influential player on Wall Street. The indictment states that Madoff held himself out as ranking “among the top 1% of US securities firms” and “clients know that Bernard Madoff has a personal interest in maintaining an unblemished record of value, fair-dealing and high ethical standards that has always been the firm’s hallmark.”     

An article in The Wall Street Journal details the scam: “Mr. Madoff ran the investment advisory as a secretive business, independent from the firm's proprietary trading and market-making operations.”
The Journal also cites two senior Madoff employees (reported to be his sons) as saying “Mr. Madoff ran the investment arm on a separate floor of the firm's offices. The two employees said Mr. Madoff kept the financial statements from the firm under lock and key and was "cryptic" about the firm's investment business.”

According to a Bloomberg.com article titled, “UBP, Bramdean, Pioneer Invested With Madoff Funds”, both European and US-based hedge funds were victims of Madoff’s scam. In addition to those named in the headline, New York based Fairfield Sentry Ltd. had $7.3 billion with Madoff. Kingate Management Ltd., run by FIM Advisers LLP in London also had money with Madoff. Additionally, Sterling Equities Inc., an investment firm run by the owner of the New York Mets, stated that he also had funds with Madoff, the article stated.

As a veteran Wall Street executive, Madoff was savvy enough to plot the deception, knowing that such a massive fraud could best be perpetrated through a hedge fund because required reporting to both the SEC and clients is far less restrictive than those of publicly traded mutual fund companies. Unlike traditional mutual funds which require investments in liquid assets that carry transparency and strict disclosure rules, hedge funds have far more latitude when it comes to types of investments, leverage and disclosure.

Opacity and loose disclosure requirements enabled Madoff to fabricate whatever returns would tantalize new investors and keep the pyramid scheme running. Because Madoff was not required to divulge holdings, his fund’s returns were merely a product of his twisted imagination.

Adding insult to injury, the scant recording documents that Madoff’s hedge fund did provide to both the SEC and clients were fraudulent, and they didn’t even match each other! Such epiphanies beg the question as to the integrity of the hedge fund databases that store the information—or misinformation, as it was.

Oddly enough, according to a Henry Blodget article from Clusterstock.com, investors of Madoff’s hedge fund are stepping forward to admit they knew Madoff was running a scam—and that is precisely why some invested with him. According to Blodget, “They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit. They didn't consider the possibility that he was clean on that score but running a good old-fashioned Ponzi scheme.”

The important lesson here is that regardless of the presumed integrity of any hedge fund company, lack of transparency, inaccessibility to liquidity and loose reporting standards make it virtually impossible to quantify the risk of any one hedge fund. Even worse, hedge funds that invest in other hedge funds add even more layers of opacity, inability to access liquidity and nebulous reporting, at best.

It is IFA’s opinion that hedge funds deliver unnecessary risk that is nearly impossible to quantify and manage, making them an unsuitable investment for all investors. This opinion is supported by the Financial Economists Roundtable, a group of 32 senior financial economists who joined together to develop a formal statement on the trouble with hedge funds (Read the statement here).

Neither individual investors nor multi-billion dollar institutions should subject their assets to the hazards of hedge fund investing. A far more suitable investment for any size investor, both individual and institutional, is a risk-appropriate blend of transparent and fully liquid  passively managed index funds —one that enables them to invest according to their own situation and preferences—allowing all investors to simply invest and relax.