A Bernie Madoff scam cannot exist under “traditional” portfolio management

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A Bernie Madoff scam cannot exist under “traditional” portfolio management
InvestorEducation / Scams
Jan 21, 2009 - 07:17 AM
By: Joseph_Toronto



“Traditional” asset management carries with it one cardinal rule which, by definition, simply does not permit a Bernie Madoff style fraud, ponzi scheme, or any other generic scam. By now most have read about the collapse of the Bernie Madoff hedge fund as roughly $50 billion of investor funds vanished in what turned out to be a gigantic ponzi scheme and the largest scam ever.



What the heck is a “hedge” fund anyway and why can you be scammed by them? Simply put, a hedge fund is an investment fund whose clients are “accredited”, meaning they have assets in excess of $5 million and income in excess of $200k. These investors are deemed by the SEC as wealthy enough to know what they are doing and in no need of SEC assistance or protections. Hence, hedge funds are minimally regulated by the SEC if at all. The key is, hedge funds take your money and do whatever they want with it. Due diligence is up to you and you alone. Having said all of that, we all know that gullibility is no respecter of persons, wealthy or not.

But what about that traditional asset management rule. It's as old as business and trade itself and not quite as old as the oldest profession, but it has certainly existed as long as money has. Even in gambling, experienced bettors always know that to protect themselves from a scam or fraud they always follow this one rule which is to have a third party hold the cash until the outcome of the bet is known and the winners are to be paid. In traditional portfolio management, a client's funds and assets are always held by a third party custodian who is “not” the portfolio manager or the investment advisor. The account is also always segregated from all other investor funds or institutional funds. The portfolio manager or advisor only has authority to execute trades, which authority obviously cannot include authority to withdraw or transfer funds.

If this simple practice is followed, Bernie Madoff could never exist, nor could any ponzi scheme or any other generic fraud. I recently saw an article stating that one of the largest hedge fund investors, also burned by the Bernie Madoff scam, is now demanding of all hedge funds in which it invests, that they begin using independent administrators immediately or risk immediate withdrawal of invested funds:

”Swiss bank Union Bancaire Privée , which faces hefty losses in the alleged Ponzi scheme run by money manager Bernard Madoff, is threatening to pull several billion dollars of investments from large U.S. hedge funds because they don't use a full-time independent administrator.

The effort by Union Bancaire Privée, or UBP, is notable because it is one of the world's largest investors in hedge funds, with about $124.5 billion of assets as of June.

Many feel the move by UDP will be followed by other investors requesting that hedge funds appoint an independent fund administrator. Responding to investor demand for transparency and independence is easier than it appears.”

Well, Union Bancaire seems to be coming around recollecting their institutional memory about investor obligations, a little late, but they also apparently seem determined to continue to stay in the hedge game in pursuit of the “big promises”. They still aren't reading the bold print in the hedge fund dhttp://madofffraud.lessonstudio.ca/images/buttons/save.pngisclosures:

“WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.”

Well, good luck to Union Bancaire. They can eliminate fraud from their universe of known risks by using third party custodians, but they've yet to come around to recognizing the source of their other catastrophic losses of 2008.

Here at Affiliated Investment Advisors, Inc. we deal with a host of custodians ranging from banks, to full service brokers such as Merrill Lynch, to discount brokers such as Schwab or eTrade. Clients deposit and withdraw their own funds at will directly from their custodian, and receive monthly statements and trade confirms directly from the custodian. We at Affiliated provide quarterly performance and activity reports to the client. When our performance is poor, it hurts our pride. We often wish we could hide it, but we can't. The client always knows from the custodian statements what has happened, and what is happening, with their money. It's a powerful incentive to perform prudently and well which we do, and fortunately, our performance thus far has been quite outstanding.

Very Best Regards,

Joe

Affiliated investment Advisors,Inc.