By Neil Wilson
The brouhaha surrounding the huge fraud perpetrated by
Bernie Madoff could hardly have come at a worse time for hedge
funds. Performance in general was deeply disappointing in 2008.
Even if the industry did, on average, beat returns in most
asset classes, the fact is that a significant majority of hedge
funds were negative on the year. And with an increasing number
imposing "gate" provisions or suspending redemptions, all too
many managers have also gotten themselves into highly fractious
relationships either with their investors or with their prime
brokers, or both.
Two key questions will dominate the debate about Madoff for
the foreseeable future. One: how did he do it? And two: how did
get away with it - how come the extensive due diligence
supposedly conducted failed to discover that the Emperor had no
clothes? There will be a lot of further investigation and
research before final conclusions are reached on those
Nevertheless, some key points can already be made - even at
this relatively early stage - about some of the lessons for the
Yet again, this is a fraud that occurred in the United
States - as have almost all the scandals since the industry
began. And the U.S. remains one of the few jurisdictions where
it is still possible to run a hedge fund without having to be
registered with a regulator. The U.S. also remains one of the
few jurisdictions where it is still commonplace to run a fund
without an independent administrator.
From the very first edition of Absolute Return back in 2003,
we have argued strongly in favor of registration and of
independent administration. To me, the Madoff case seems to
demonstrate yet again how important it is for the industry to
have more checks and balances - as it already has in most other
parts of the world.
Of course, there are arguments against registration, as well
as against independent administration. Those who oppose such
developments will not be slow to point out that the SEC hardly
covered itself in glory in its regulation of Madoff as a
broker/dealer - within which this fraud was perpetrated; and
secondly, that various of the Madoff feeder funds, such as
Kingate and Fairfield Greenwich, did retain independent
administrators - who were seemingly ineffective at helping
investors detect the fraud.
There are various reasons, however, why I think Madoff
presented a highly special case - and hence why it does not
invalidate the need for more industry oversight.
The Madoff funds were run within an exceptionally unusual -
probably unique - structure, in which Madoff himself was not
the "manager" but merely a kind of subadviser who charged
commissions to the feeder funds. This should of course have
served as a major red flag to potential investors - as to why
he would willingly forgo the 20% performance fees picked up by
a normal manager and allow those to be picked up instead by the
A second major difference was that - unlike most hedge funds
- Madoff did not use any independent prime broker. Hence, any
administrator that checked the trades claimed during a
reporting period could check the audit trail with only one
source - Madoff Securities.
The administrators may or may not have done their jobs
properly - they certainly have some tough questions to answer,
and that will only be established in time. But the problem was
arguably more with the absence of independent prime brokers.
And this again, of course, should have served as a red flag for
The fact that Madoff itself did not possess a credible
auditor is something else that should of course have been noted
by investors, or those doing due diligence on their behalf.
To us, it seemed for quite a long time that something was
suspicious - if not about the size of the returns reported by
Madoff, then the unbelievably smooth return pattern. For it to
be possible, I felt Madoff must have discovered some new and
undetectable way of "front running" customer orders - or that
he was a fraud.
We now know, of course, that the SEC was approached by at
least one party who argued forcefully it should investigate.
Not for the first time, the SEC was not up to the task.
Nevertheless, it does not seem right that the SEC should be
excluded from the industry, and even less likely to occur. A
better solution is surely for the SEC to improve its game. If
it can do that, with a system of registration and sensible (not
heavy-handed) oversight - which I admit is a big "if" - then it
may be possible both to deter future fraudsters and to
encourage a healthier, more robust industry in the future.