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.