FYI: Madoff Didn’t Run a Hedge Fund: But You Would Never Know it By Reading the Press

I worked in the hedge fund world for over 10 years, or most of my career.  All of them were legimate and great tools for high net worth investors to diversify part of their portfolio, and depending on the strategy, either hedge against market risk, or swing for the fences through leverage.

Recently, however, the media has been clamoring over the chance to call for the “much needed” end of hedge funds citing the Madoff scandal as the final nail in the proverbial hedge fund coffin.  One small problem with that though: Madoff didn’t run a hedge fund.  He was a Registered Investment Advisor (RIA).  Let me say that again with emphasis on the word “Registered”.  He was a Registered Investment Advisor (RIA).  Registered as in registered with the Securities and Exchange Commission.  So if a registered advisor can get away a $50 billion scam, do you really think the SEC would have the man power to stop hegde fund fraud whether they are forced to register or not?  As a RIA, Madoff was subject to the Investment Advisers Act of 1940.  Guess what? So are hedge funds whether they register as an RIA or not.  Hedge funds are subject to the fraud provisions of the Advisers Act and their managers have the same fiduciary duties as other investment advisers.  Those that say that hedge funds are unregulated are simply wrong.  The problem isn’t one of regulation per se. The problem is one of enforcement. 

Regardless, any investor in any investment, has the opportunity to do their due diligence before investing, whether it be with a hedge fund, mutual fund, stock, bond, private investment, or with the Madoff’s of the world.  Nothing short of staying on the sidelines can fully eleviate risk of an investment.  But just a little due diligence before investing in Madoff would have saved those investors that lost money.  Problem was Madoff didn’t even give his investors the chance.  Madoff was known for not letting potential or current investors visit the office to perform any due diligence.  In contrast, I would say that approximately 95+% of large hedge funds will allow due diligence to be performed on their firm.  There were plenty of other red flags about Madoff too (investors didn’t even get trade tickets and the guy used an unheard of auditor), but between his stature in the investment community and the blind hope in the fantasy that 10-12% annual returns year after year were possible,  investor’s judgments got cloudy.    

Hedge funds have been getting a bad rap since Long Term Capital Management’s (LTCM) collapse in 1998-2000. Probably before that in certain circles, but I don’t remember hedge funds getting publicly abused before LTCM.  Hedge funds were fairly unknown before LTCMs infamous blowup to the tune of $4.6 billion.  To be fair, it has been easy to despise hedge funds.  The investors in hedge funds are either rich individuals or even richer institutions.  The managers of hedge funds make a ton of money and are rich too.  They are seen as the elite investment for the elite ,so that the elite of the elite can get even more elitist.  Until one blows up, then it’s; “The poor investors got defrauded by another crooked fund manager.”  Hedge funds for the most part are secretive.  And the only ones we ever hear about are the ones that end up as scams or take a huge leveraged bet in the wrong direction and blow up.  Seems like everyone is on the hedge fund hating band wagon.  James Cramer, Warren Buffet and Henry Bloget included.  Talking about all the thousands of hedge funds that beat the S&P each year does not make for juicy news.  By the way, even in 2008, arguably one of the worst years for hedge funds ever, hedge funds were down approximately 23%.  The Global market, however, was down 44%. But what do we hear about? That hedge funds outperformed the overall market by 21%?  No. Just that hedge funds were down 23%.  How did your stock portfolio do in 2008?  Mine too.  Would it be news if the market ended up 6% in 2009 and hedge funds were up 27%? Would the papers be flooded with the success of hedge fund hedges?  Or better yet, if hedge funds returned 5% in 2009 with have the risk taken. Would that be reported?  Maybe, but just to say that hedge funds underperformed the market.  To compare returns without talking about the risk it took to get those returns is naive to say the least.

Without a doubt though, there will be far less hedge funds in existence by the end of 2009 than their were at the end of 2007.  Just like there will many less lenders, mortgage brokers, realtors, and banks.  Less people with jobs too.  But, believe it or not, there are some overall market benefits to keeping hedge funds around before we all grab our pitchforks and torches and head for the castle.  It’s not all about making the rich richer.  One easily recognizable way that hedge funds can benefit the markets is by providing liquidity.  Many large financial institutions have exited (mostly involuntarily) from certain markets, e.g. lending and the MBS market.  Hedge funds have picked up the slack in many of these areas.  Other areas include market-making , insurance underwriting, venture capital, and trading convertible bonds.

Alfred W. Jones would not be proud.

After Rates Go to Zero, What Happens Next? Or, Why Does the Fed Seem to be Acting So Wacky?

First off, I’m no economist. I mean, I have studied it in school and recently in my studies as a CFA Level III candidate, but trying to write a bit about even just a small part of what is going on right now is tough and may prove to be mere folly.  There are so many variables to consider. So many moving targets, changing relationships and new correlations/relationships introduced between variables.  It really needs to be a full time job to study all this… stuff.  And it seems that economists get it wrong more times than not anyway, so why even bother?  I don’t know, but I like to write about it, so here it goes…

As you may know, on December 16, 2008, the Fed lowered the fed funds rate (generally defined as the interest at which private depository institutions lend balances at the Federal Reserve to other depository institutions, usually overnight.)  Typically, such low interest rates have been associated with periods of deflation (a drop in consumer prices).  Pundits are still undecided if we are in period of deflation or not.  Sure seems like it to me with the collapse of the energy and commodities bubble.  Maybe these are the same pundits that couldn’t make up their minds if we were in a recession or not until a few months ago. 

The Fed uses the fed funds rate to heat up the economy by lowering the rate to stimulate borrowing, spending, and to loosen credit markets.  But, once the rate goes to zero, obviously, this tool no longer applies… it has been used up so to speak.  So what happens then? What other measures are available to the Fed for further monetary stimulus?  Many have already been instituted by the Fed during most rare and damaging financial crisis.  Drastic times call for drastic measures I guess.

1) Pushing cash (bank “reserves”) directly into the banking system.

We certainly have seen plenty of this. Since rates were already so low, the Fed tried to bypass the system by injecting cash directly into the system.  $8o0 billion last November alone.  But if there is no desire to borrow or lend, the method will have limited effect.  Just go ask Japan.

2) Promise to hold short-term interest rates low for an extended period of time. This can have value normally if markets do not think that rates will soon raise due to an expected recovery.  I’m pretty sure that most market participants believe that the recovery is a ways off. People saying by the end of 2009 are kidding themselves. Keeping rates so low also forces banks to lend or suffer loses as yields on bonds they own become lower than their cost of funds.  A shout out to Mark Sunshine at Seeking Alpha for shedding some light on the other current reasons for keeping rates next to nothing. Check out his article “How the Fed Is Making Banks Lend”.

3) Buy assets directly from the private sector.

AIG, CITI, Freddie and Fannie, MBSs, TARP.  It’s been a toxic spending spree of historical proportions.  Most of this has been to add much needed liquidity to the credit markets.  And to drive down yields on these assets. Japan has been doing this for years.  1o year bond yields have been driven down below 1% at times.      

4) Devalue the currency.

Increase the money supply and the dollar gets devalued.  Maybe those undecided-on-deflation-or-not pundits have a point.  The dollar certainly has been falling as of late, after a nice rise, but also after a long decline.  So how much further can it/will it drop this time around?  Is this the last tool left for the Fed in the fight against the severe recession? Maybe, it is time to book that trip to Europe now rather than later.  For those of you who can still afford it that is.

An Introduction to Your Most Humble Host.

Greetings.  This blog, my first, will hopefully serve as an outlet for me to observe, rant, laugh at, and maybe even cry about, the world around me.  Topics will range all over the place as my brain is in constant flux.  My background is actually in law, real estate, and mostly, finance (the often misunderstood world of hedge funds to be exact).   I possess an extremely creative mind that I hope to tap into through this blog.

I am not sure what type of disclosures are needed for blogs.  But, please…. do not rely on or act upon anything I say.  Rather, enjoy and maybe question the world around you as I do.  To think, commiserate, partake with comments.

So without further ado, and hopefully some of you are still reading, I shall take a break and begin on my first topic shortly. Thank you for sharing.

But before I go, my first observation is: Why does the Spell-check on a blogging site not recognize the word “blog”?

-WF