Tremont All Hedge index down 26% in 2008 Troubling questions about Madoff - Tremont hedge 'loses $3.3 bln in Madoff scandal'

Troubling questions over Madoff scandal

Jan 04, 2009 04:30 AM

ELLEN ROSEMAN
New York money manager Bernard Madoff was charged with fraud last month after confessing that he had been running a Ponzi scheme, with losses that could top $50 billion (U.S.).

For years, he had allegedly been paying returns to certain investors out of the principal received from other investors, according to a U.S. criminal indictment.

Madoff allegedly gave up the game when he received $7 billion in redemption requests that he couldn't meet. There was not enough cash from new investors to repay earlier investors, according to investigators.

How did so many smart people – including some Canadian hedge fund investors and charities – fall into the trap? Were there any warning signs that should have been heeded?

After devouring any nuggets of information I found about this alleged fraud, I've come up with three cautionary questions for investors.

• One: Do you understand the investment strategy?

Madoff allegedly told clients he used the "split strike conversion strategy" to stabilize an existing portfolio. Known as a collar, it's a combination of a protective put and a covered call that limits risks and also limits rewards.

Other managers using similar strategies could not match his returns, nor could they avoid having any down months.

• Two: Who's recommending the investment? How do they profit from the recommendation?

Many hedge funds acted as intermediaries and earned percentage fees for finding superior managers for clients. These "feeder funds" could become wealthy by getting a chunk of the Madoff cash stream.

Was it wishful thinking or blindness that made them believe Madoff could escape the losses that everyone else was facing?

The Credit Suisse/Tremont All Hedge index, for example, lost 26 per cent of its value through November of last year. (It's a good performance indicator for funds of hedge funds.)

While the index did outperform the S&P 500's minus 38 per cent, it was far from the positive returns that most investors were promised. The failure of Madoff's funds, which were a sizable component of the index, will magnify the poor performance.

The Credit Suisse/Tremont index of hedge funds actually fell 4.15 per cent in November – a sharp downward revision from the small 0.71 per cent drop originally reported for the month.

• Three: Who's holding the assets?

Mutual fund managers don't hold the assets they're entrusted with by investors.

They must use an independent custodian, an arrangement that protects the public if the manager goes under.

But in this case, Madoff Securities, the brokerage unit, initiated trades for Madoff's investment business, executed the trades and was the custodian and administrator of the assets.

That Madoff cleared his own trades, with no external custodian, was worrisome. Can securities regulators do more to protect investors?

Christopher Cox, chair of the U.S. Securities and Exchange Commission, has called its handling of the case "deeply troubling" and promised an investigation of its "multiple failures."

With a new U.S. president taking office this month, the SEC may be revamped. But Canadians, too, need more protection from failures of security regulation.

Ellen Roseman's column appears Wednesday, Saturday and Sunday. You can reach her at 416-865-3630; or at eroseman@thestar.ca.