The Ponzi hedge fund

Sebastian Mallaby:

For sheer toe-curling embarrassment, it may be a while before Wall Street does better than the Bernard Madoff scandal. Here was a rogue who practically telegraphed his unreliability by hiring a tiny, no-name audit firm, by reporting monthly investment results that never fluctuated and by claiming a trading strategy that could not possibly have been implemented given the billions of dollars he managed. And yet, despite these warnings, the rich, the famous and the supposedly sophisticated entrusted their money to Madoff, who defrauded them with the most laughably crude of methods -- an old-fashioned Ponzi scam.

The question this prompts is not really about regulation, though some argue otherwise. Even if you define Madoff's investment outfit as a hedge fund, which for various reasons is debatable, there's nothing in this saga that supports clamping down on the industry.

Those who favor regulation of hedge funds start by insisting that they must register with the Securities and Exchange Commission. Well, Madoff had registered with the SEC voluntarily, and a fat lot of good it did. Those who support regulation also say that hedge funds should disclose more of what they do. Well, Madoff did make some disclosures; it's just that they weren't true. As SEC Chairman Chris Cox has all but admitted, the scandal doesn't show that his agency lacked the power to regulate; it shows that it failed to exercise it. Responding to this scandal with more regulation would be like thrusting more pills on a patient who refuses medication.

The real question posed by this episode concerns the market's response. Madoff illustrates a problem with investment outfits that claim to have some special sauce that is too valuable to discuss. People who entrusted their money to Madoff thought he had a clever options trading strategy; they were wrong. Worse, people who entrusted their money to respected banks and investment advisers had no idea that their savings were being passed out the back door to Madoff. On Monday, I happened to be visiting one of the most famous traders in Manhattan. He had invested with a hedge fund that had in turn invested with Madoff, hot-potato style.

The good news is that Madoff's fraud was so brazen that any future imitators may be spotted. A newly chastened wealth management industry will be warier of people who hire bucket-shop auditors; the "fund of funds" industry, which gets paid to do due diligence on hedge funds, will feel appropriate pressure to redouble its efforts. Even though hedge fund managers may legitimately refuse to disclose their trading strategies, there are some things they can be open about. Do they trade through a respected external broker? (Madoff apparently didn't.) If their returns clock in at 1 percent per month with eerie consistency, can they explain why? (Madoff could not have.)

But the bad news is that less-brazen fraudsters may be impossible to detect. As the economists Dean Foster and H. Peyton Young have elegantly demonstrated, hedge funds can fake brilliance by taking a small risk of implosion, and since implosion would hurt them less than their customers, some will rationally decide that faking is the way to go. A fund can take in $100, stick it in the S&P 500 index, then earn, say, $5 by selling options to people who want to insure themselves against a market collapse. If the collapse occurs, the hedge fund's value will go to zero. But, over a five- or even 10-year time frame, the odds are good that a collapse won't happen. So each year the fund manager will beat the S&P 500 index by 5 percentage points. He will be hailed as a genius.

...

Hedge funds are supposed to be anti gravity machines that can make money which ever way the market moves, but bad markets have a way of exposing bad strategies or in this case out right fraud. I think the chances are remote that Madoff's scheme could have survived a tough audit from a strong accounting firm. Regulators need to give special attention to firms who use accountants that have a small group of clients. A request for the accountants work papers in this case should be very interesting.

As an aside, sometimes attorneys for investors like to use the S&P 500 average as a base for damage calculations when their clients portfolio does not perform up to the average. My question in that situation is if that is really what they were aiming for, why didn't they just buy an S&P 500 mutual fund?