It's the end of Bernard Madoff's legacy - but is it the end of hedge funds as well?

/Home/Madoff Fraud to Impact Fund Management Biz/Madoff Fraud - Impact on Hedge Fund Business/Will Madoff Fraud Signal the End of Hedge Funds

ALEX BRUMMER: Is Bernard Madoff's £33billion fraud the death knell for the hedge fund?

The £33billion fraud by Bernard Madoff could spell the end for the most controversial investment vehicles of recent years: hedge funds.

His scam, nothing more than a huge pyramid selling scheme, highlights the dangers of the unregulated hedge fund business.

He managed to convince some of the most highly-regarded banks, financiers, investment trusts, entrepreneurs and charities that over time he could produce better and steadier returns than most other fund managers.

It's the end of Bernard Madoff's legacy - but is it the end of hedge funds as well?
The key to his fraud was simple: he used the money given to him by new investors to pay the returns promised to the rest.

A hedge fund is a private investment group open to a limited number of very wealthy investors. It is allowed to undertake a wider and more aggressive range of activities than other firms including shares, dealing in debt, commodities and so on.
Because Madoff had a reputation as a relatively conservative investor, nobody bothered to ask how their money was being invested. It was taken on trust.
His hedge fund was part of an unregulated industry which grew by leaps and bounds in the credit-fuelled atmosphere of the last few years. In 2005 some $1,000billion was invested in thousands of hedge funds which had set themselves up in London, New York and in offshore financial centres. By the peak of the credit boom in 2007 this sum had doubled.

Pension funds, investment trusts and insurance companies around the world all wanted a bit of the action and the wonderful returns which had been enjoyed only by rich private and family investors. But these highly-regulated institutions were placing the money of ordinary investors in a marketplace where the law of the jungle operated.

Hedge funds were at the forefront of the short selling of Britain’s banks this year.

Short selling is where the hedge funds borrow shares from major holders with the promise to return the same number of shares to them at a later, specified date.

The speculators sell the shares immediately at the prevailing price on the stock market. The goal then is to drive the price down, buy the shares back at the lower price and return them to the original holder having pocketed the difference.

The practice brought chaos to the markets and was regarded as so destabilising that it was banned by the Financial Services Authority.

By sharing market intelligence and acting together, hedge funds can drive the share prices of quoted companies up and down at will for short-term gain rather than long-term investment.

It was their abhorrent behaviour and manipulation of share prices which led to several of Britain’s biggest companies – including BAA, ICI and Pilkington – being sold to overseas buyers.

This year has been the most destructive in world financial markets since before the First World War. But no one guessed that amid the detritus of the sub-prime mortgages and the banking system there lurked the greatest fraud of all time.

If this were to mean the end of hedge funds, few ordinary consumers would mourn the passing of these havens for the greedy investor. The trouble is that an already precariously-weak financial system can ill afford yet another shock so hard on the heels of those it already has suffered.