The alleged fraud of $50bn at Bernard Madoff’s investment advisory business will send a scare through the fund-of-funds that put investors’ money in hedge funds in return for a fee, but the implications for hedge funds are less obvious.
His business, although hedge fund-like, was not structured like most hedge funds, and there would have been more safeguards if it had been. It would be very hard for most hedge funds to operate Ponzi schemes, as Mr Madoff is alleged to have done.
This paradox cropped up in the New York Time story on the scandal on Friday. Early in the piece, it said:
The collapse of Mr Madoff’s firm is yet another blow in a devastating year for Wall Street and investors. While Mr. Madoff’s firm was not a hedge fund, the scope of the fraud is likely to increase pressure on hedge funds to accept greater regulation and transparency and protect their investors.
Further down, however, it added:
Mr Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JP Morgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.
Well, indeed. Long-running financial frauds often depend on the same person having control of the front and back office – not only making trades but having oversight of clearing and settlement. If Mr Madoff was engaging in fraud, as alleged, it was very helpful not to have others checking on his trades.
The problem is less for hedge funds than for funds-of-funds. Some, including Fairfield Greenwich Group and Tremont Capital Management, directed money to Mr Madoff’s fund management arm and got fees for it, but do not seem to have grasped what was going on.
