Lessons learned from Madoff fraud allegations - Something "Too good to be True" probably is

Lessons learned from Madoff fraud allegations
by Steven G. Kelman | 23 Jan 09 | E-mail Article to a Friend

Fund managers, advisors and investors should look beyond the numbers.

I have some advice for anyone who owns hedge funds that invest in other hedge funds: Ask the management of your hedge funds to explain its due diligence procedures in detail.

If you bought a fund on an advisor's recommendation, ask him or her to explain in detail the due diligence that was performed before the fund was put on the firm's approved list, and what are the qualifications of the people who performed the due diligence.

I expect in light of the losses stemming from hedge funds managed by Bernard Madoff and his alleged US$50 billion fraud, Canadian investors who invested in funds that indirectly had money with Mr. Madoff's funds will be making enquiries of their fund managers and advisors. Regulators in the United States allege that Mr. Madoff ran a Ponzi scheme in which money from new investors was used to pay returns to earlier investors.

Mackenzie Financial used Tremont Capital Management Corp. to manage its Mackenzie Alternative Strategies. Tremont invested most of the money in one its own funds that placed some the money in funds invested by Mr. Madoff. Mackenzie is in the process of winding up its fund.

The Mackenzie fund declined 44.5% in December. At year-end 91% was invested in Cayman Islands-based Tremont Opportunity Fund Ltd., which reportedly invested about 20% of its assets in Madoff funds.

The Mackenzie fund was aimed at sophisticated investors with a high tolerance for risk. The offering memorandum noted that "The Fund may be suitable to diversify an investor's larger investment portfolio."

Mackenzie wasn't alone. Several Canadian banks had clients who lost money and at least one Toronto charity announced a loss. Other high-net-worth individuals and corporations might have invested directly in Tremont funds. Tremont had an office in Toronto but its registration in Ontario as a limited market dealer was suspended effective December 10.

Tremont is described on Mackenzie's website as "the largest advisor to multi-manager hedge fund portfolios worldwide. Tremont's clients include major financial institutions, funds of funds, pensions, endowments and high-net-worth families" and "the only major hedge fund specialist with substantial operations in the U.S. and Europe."

Everyone who uses an investment professional for advice or a fund management company which in turn hires out the management function to other companies should be able to expect that the professionals did their homework prior to making a recommendation or contracting with a sub-manager. They have a responsibility to their clients to do so.

Unless someone performed adequate due diligence there is no way on earth that an advisor could meet his or her obligations to recommend only securities that are suitable. If someone doesn't perform a thorough due diligence analysis and consequently doesn't understand all the risks, the advisor is in no position to explain the risks to the client as securities regulators require.

Years ago advisors could rely on the information in the offering memorandum and other documents that the issuer might provide. But for at least the last decade regulators have required dealers to look beyond what a promoter or issuer provided, in particular when the security was sold under a prospectus exemption. Simply put, if the documentation omitted material facts, a potential investor would be unable to make an informed opinion and would be dependent on the advice of the investment dealer and its sales representative who needs to know the product in order to know whether it is suitable for the client.

I don't think it's asking too much of a fund management company that decides to add a hedge fund to its product line and use an outside manager to find out how that company manages money. If it's a fund of funds that means finding out who are the sub-advisors and how they manage money. The outside manager should be able to provide that information and confirm how it supervises sub-advisors and monitors transactions, including payment transfers stemming from trades and whether it confirms with third parties that the trades took place.

It's not really that complicated. It means someone must look beyond rates of return. The level of due diligence required will vary by organization and fund. Where little public documentation is available analysts should be responsible for looking at all transactions over a year or two and for asking a bunch of questions about philosophy, procedures and portfolio structure. The analysts should look at depth of analysis, trading costs, borrowing costs and whatever else their line of questioning leads to. They should review the research documentation or trend analysis or whatever the fund uses to base its decisions on.

If the fund does in fact use some sort of complicated, multifaceted, intricate derivative strategy that is rocket science and is too complicated to explain to a governance committee or can't be understood by most other investment professionals and potential investors, my advice is walk away.

Similarly, if the fund doesn't want to provide the detailed information that is required because its procedures are proprietary, find another manager. No doubt funds have to keep their current trading secret to avoid front running -- trading based on the knowledge that another investor plans to buy or sell. But signing a non-disclosure document should take care of that.

Steven G. Kelman is an investment counsel and president of Steven G. Kelman & Associates Limited. His company provides specialty publications and training for the mutual fund industries. Steven is the author of several personal finance books and is author or co-author of courses offered by the Investment Funds Institute of Canada, including the Ethical Conduct and Behaviour continuing education course and the Labour-Sponsored Investment Funds course. He received a B.Sc. from McMaster University, an MBA from York University and holds a Chartered Financial Analyst designation.

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