Your Humble Blogger Dodged the Madoff Bullet!

L’affaire Madoff continues to garner front-page coverage. Yet I find the stories peculiarly unsatisfying, since they are peeling the onion one layer at a time, failing to answer the questions I find most interesting: was his fund ever a legitimate operation, or was it a con from the beginning? And where did the money go?

But even at this stage, the reports are indirectly throwing a very unflattering light on funds of hedge funds. The justification for them is tenuous. UBS offers the typical rationale:

Hedge funds-of-funds are multi-strategy, multi-manager hedge fund portfolios assembled to provide a diversification alternative to single-manager funds. Hedge fund-of-fund managers develop and implement the multiple strategy allocations, identify and hire the underlying investment advisors, allocate capital among the strategies and managers and monitor the performance of the underlying funds. Investors, as a result, receive the benefit of a professionally researched, commingled investment without committing substantial resources to manager selection, portfolio construction, ongoing risk management and rebalancing.

It also lists as an advantage:

Access to hedge funds that might otherwise be closed to new investors

The big problem with fund of funds is the big fees on top of already sizable hedge fund charges. Hedge funds typically charge a 2% annual fee plus a 20% performance (sometimes absolute, sometimes over a benchmark). Fund of funds add another 1% annual fee and as much as a 10% performance fee (although in this difficult market, some FOFs are cutting annual fees).

With all those haircuts, there isn’t much performance left when all is said and done. From Sharpe Investing:

According to Business Week, the average hedge fund of fund had an annualized return of 6% over a four year period ending March 31, 2006. The S&P 500 had an annualized return of 7.25% over the same period. While the risk levels of these investments may be different, this example illustrates the adverse impact of high fees compared to a common benchmark.

But FOFs offer another key advantage: their minimum required investment is often lower than for stand-alone hedge funds. And they may have shifted investor behavior. The idea that you could get into high return investments and have someone vet them and figure out how to mix them up would make them seem less risky (investors too easily forget that in a really bad market, as the LTCM debacle and the second half of 2008 showed, in a meltdown, correlations move to one, that is, previously uncorrelated investments move together). And the belief that these FOFs tamed hedge fund risks no doubt lead investors to overallocate to this strategy. That was no doubt compounded when firms like UBS made promises in their marketing materials (in this case, that they actually held the fund’s assets) that went beyond what they actually did.

But Madoff is now embarrassingly exposing that quite a few hedge fund of funds didn’t do their job. Various investors and hedge fund experts have said they told clients to steer clear of Madoff because the returns didn’t add up and/or they couldn’t get straight answers to normal due diligence questions. An SEC submission in 2005 listed 29 red flags and concluded Madoff was either front-running customer order flow or a Ponzi scheme.

There are a couple of new, longer-form stories out today, both seeking to give a bit more color to how such a fraud could have reached such a scale. Both the FT piece, “No questions asked” and the New York Times’ “Madoff Scheme Kept Rippling Outward, Across Borders” are very much worth reading.

The Times piece describes how the Madoff net, both investors and “feeders”, fund of funds that put client assets into Madoff, grew and evolved, and implied that, toward the end, the fund was being flogged so far and wide that it could hardly be characterized as exclusive and hard to get into, even though that was part of its allure.

I can attest to that. Even though I am a very unlikely target for a fund of funds, I managed to cross the Madoff path, unbeknownst to me.

A friend who had invested in a new hedge fund of funds put me on to one of the founders (he thought she could help answer some questions I was trying to nail down). The co-founder gave a low-key sales pitch, and one of the distinctive things about the fund was that it had access to funds that were closed.

That firm was mentioned in the Times story as one of the feeder funds.

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  1. Anonymous

    1. Overall hedge funds perform worse than just buying and holding index funds. It cannot be otherwise.

    2. Adding another layer of fees on top of that is just double folly.

    3. There was an article today about how Madoff had been ripping people off since the 1970’s.

  2. ndk

    1. Overall hedge funds perform worse than just buying and holding index funds. It cannot be otherwise.

    Of course it can be otherwise. Where there are market inefficiencies, there is potential profit. As an example, the original arbitrage funds did grotesquely well during the ’70’s, ’80’s, and early ’90’s.

    But there’s a lot of feedback. Not only were the inefficiencies lucratively squashed, but as the hunt for trades grew more desperate, the correlation between asset classes soared. The opportunities for these funds decreased rapidly as they proliferated and as AUM grew.

    This is all IMO bad for the system and economy as a whole. Pricing mechanisms begin to break under the sheer force of such assets and leverage, valuations lose their meaning, and volatility and risk appear to collapse.

    The morning after turns out to be a lot longer than a handful of hours spent wretching over porcelain.

  3. Steve

    When did the fraud start? Well, Fairfield Sentry, Madoff’s alter ego, showed smooth returns from Dec. 1990 forward. It’s a good bet that the fraud started even earlier — i.e. that Madoff’s returns prior to 1990 were magically consistent enough for the clowns at Fairfield Greenwich to go with him.

  4. Anonymous

    As an example, the original arbitrage funds did grotesquely well during the ’70’s

    Keep on believing in that magical pixie dust, ndk:
    “According to Eichengreen and Mathieson, assets managed by the 28 largest hedge funds had declined by 70 percent in 1970. Many were liquidated, and the total value of the remaining hedge funds at the time was $300 million.”

  5. ndk

    Keep on believing in that magical pixie dust, ndk:

    Those were just leveraged longs or long-short funds, and that’s just AUM, Anonymous. You could point to the 1920’s investment trusts too. Arbitrage is an entirely different game and didn’t emerge until later. These funds cannibalize themselves as they grow and most of them probably go under here, more spectacularly than any prior bust.

  6. Kevin de Bruxelles

    That was a very interesting internal SEC report on Madoff written in 2005.

    It makes me wonder if there wasn’t actually a pretty good reason for the SEC to not shut Madoff down. Namely, that on the wholesale level, he has been for the last few years basically transferring his scam from American to European investors. In other words, it seems likely that he was redeeming his earlier American investors with new European money. If the SEC had shut him down in 2005 then many American investors would have been worse off than allowing the scam to keep going, fuelled mainly by either foolish, or treasonous, European funds. For the last three years, European clowns have basically been bailing out Americans who had figured out by then that they had been clowned by Madoff.

    Of course when the scandal broke the American media touchingly displayed a wealthy American face to the losers by emphasizing the retail side of the Madoff scam. But the amounts lost by the country club set pale by a factor of at least 1000 compared to the losses incurred by the faceless European financial institutions.

    To be clear, if this is what happened, then the fault would not be so much with America, since it’s been clear for years that the only people regulating anything over there are Warren G and Nate Dogg. Instead, the blame lies with careless European investors and regulators. Unfortunately Europeans have been taking huge losses on real estate / financial scams in American all year long with barely a whisper of outrage.

    Are European investors really that stupid or is there a large agenda at work here?

  7. foesskewered


    just a guess but which investor, particularly the institutional ones, wants to be seen as the “naive” one who fell for short termism and the con? outrage gains them nothing but humiliation after loss. they are after all the best brains in the business. how’s fortis doing btw?

  8. Richard Kline

    There’s a nice take on the ‘affinity scam’ aspect of Madoff’s pyramid—his fulcrum was shaking down wealthy Jews—by Alexander Cockburn over at Counterpunch, too, for those who want that angle.

    And Kevin de B., the only Americans who were ‘bailed out’ as you formulate the sequence where those who redeemed more than their initial entry, or who cashed out entire. Those were few; most seem to have stayed in because the returns were so sweet, as was the view from Mt. Croesus—and have lost their wad. A prominent long time investor and friend of Bernie “Madman” mentioned in the Counterpunch piece was said to be down $500M; that’s not bailed out but rather trashed out. I have little pity.

    The angle that _I_ want explained is, just how blind could the Fed dogs at SEC be? They ‘investigated’ in _at least_ 91, 01, and 05, and found so much garbage in the last that any normal shop would have had police tape all over it, judging by the complaint mentioned in comments here and elsewhere. The nonfeasant ‘investigations’ strike me as highly suspicious. The reality, at best, is that Bernie Madoff was Mr. Insider, and nobody with subpeona authority could quit grovelling long enough to take a whiff o’ the stink. In the US of A, we worship money, and Madoff was a demi-god; try chewing on that as the least bad explanation, folks. And yep, that’s the America I’ve been living in for 30 years.

    And re: the funds of funds angles, in a bubble, the induced price vector is an inherent underlying correlation. For the funds of funds strategy to even have a hope of working, we would have to have operative business cycles; you know, those things St. Alan Greenspin and legions of academic economists did their damnedest to flatten on a rightward incline. Thereby auto-correlating all asset classes. This is something that I don’t believe I’ve seen framed in quite those words, though the concept has been discussed over the last year and a half: ‘Permanent growth’ correlates inherently. And we now see how that plays to long-term horizons.

  9. Kevin de Bruxelles

    And Kevin de B., the only Americans who were ‘bailed out’ as you formulate the sequence where those who redeemed more than their initial entry, or who cashed out entire. Those were few; most seem to have stayed in because the returns were so sweet

    Fair enough Richard, but where did the $50 billion go then? Someone was getting paid. I don’t mean to imply that many of the retail level people were getting bailed out (redeeming) but what about some of the larger players? Where was all this money going in recent years? Since it was a scam from the get go, in my opinion, Madoff would not have been losing money desperately making risky trades. Billions of dollars were flowing in to Madoff from Europe, now supposedly he has nothing, whither the outflows?

  10. kevin de bruxelles


    There has been an undeniably huge transfer of wealth from Europe to the US over the past few years. This has been executed through the purchase of toxic US assets (mortgage based financial instruments, AIG products, Madoff, etc) by major European financial institutions. Bright, intelligent and patriotic European financial wizards should have had a pretty easy time understanding the housing, credit default and Madoff scams. Maybe it’s all innocent; European bankers are just naive idiots who are easily taken to the cleaners by clever Americans.

    Or maybe something else is going on. There is decidedly minority opinion in Europe that believes radical Americanization of society here would be in their interests. What better way to bring that about than by “innocently” bankrupting Europe by transferring huge amounts of wealth to America.

    I don’t know, but every week brings about new revelations of billions of Euros lost to America. And the general population here have yet to express any outrage about this. The least I can say is that this is a worrying trend.

  11. Anonymous

    Unbelievable !

    Instead, Madoff has agreed to a nightly curfew, and his wife, Ruth, will surrender her passport, according to a filing in U.S. District Court on Wednesday. Madoff has already given up his passport. He must remain at his apartment in Manhattan from 7 p.m. to 9 a.m.

    During the day, he will still be allowed to travel throughout Connecticut and southern New York. Previously, he had had no restrictions on his travel in those areas, allowing him to sleep at his oceanfront estate in Montauk, on Long Island, if he chose.

  12. Anonymous

    I am also asking about where that money went. 50 billion dollars, even if it’s based on 5-10 billion of actual invested cash, requires accomplices, not just individuals, but some kind of institutions who were knowingly corrupt.

    Another thing that concerns me is that Ponzi scams are *very* stable scams, and if you got one that was at all stable in the billions of buckaroos, it could last quite a bit longer than your lifetime.

    I think Madoff made a bunch of spectacularly ill-advised investments using the false size of his pile as collateral. 50 billion dollars isn’t what was defrauded, but a *combination* of lost capital and a huge pile of unpayable debt.

    I think Madoff was a known quantity in financial circles. I think the original bailout language reflected an intent to make the counterparties of people like Madoff whole. I suspect that the entire arrest and subsequent media stories are an elaborate ringamarole to hide the culpability of unacceptable figures.


  13. Sundar

    Isn’t this shocking that so many and so called Investment Pros failed to follow certain basic tenets like Prudence, fiduciary duty and worst of all, utter disregard for Due Diligence!

    There is no substitute or more need for self education and critical thinking re your own financial destiny. I got my lesson after my mistakes in early ’80s! I know I preaching to choir here!

  14. VoiceFromTheWilderness

    Count on the investigation to continue to be superficial, and in the end the real story clearly uknown. Count on the penalties being so light that from the point of view of a wage earner the crime will still count as the best work one can imagine.

    It is hilarious to watch hedge fund people worry about whether their investments are ‘safe’. It is duplicitous and utterly selfish for people to ask publick institutions to regulate and prosecute economic activity that was specifically, and legally unavailable to the public, and even funnier that the reason given us rubes was ‘our safety’. Since hedge funds were ‘risky’ we were told we could not participate — oh thank you great and glorious God of Capitalism for your concern about our well being. Now they suddenly discover that hedge funds really were risky, and who do they want help from? Public institutions.

    Can you spell entrenched aristocracy? Can you spell two-tiered Justice? Can you spell public theft for private profit? Ca you spell government enforced economic power pyramid? (oh that evil government) Can you spell right wing free market libertarian con-artists and fools?

    I knew you could.

  15. Mara

    @anon “Who put up the $10 MM bail for this scum bag ? That is likely where the money trail begins.”

    Madoff’s wife did, secured by his NY apartment, which is part of the ill-gotten gains, without a hint of irony. However, the bail terms increased and he was no longer allowed out of his house and the wife is now required to have security@ the door. That security will have the ability to alert FBI surveillance if there is an attempt at escape or injury. Maybe they’re worried some angry investor will plug him before they get all the data (or more likely, provide cover for the most connected fund holders).
    I think it was on yahoo message boards, a charge that a bank in Israel was offering Madoff clients the ability to withdraw funds, at least up to the amount that Madoff apparently had wired before the bust. This is rumor-line, taken with a big grain of salt, but not an unlikely action.
    Personally, I doubt the sons turned Bernie in because of civic duty, merely as part of the general scheme. Hopefully there are some persistent hounds following the money on this.

  16. spare some change?

    @kevin de bruxelles

    You’re beginning to “get it”. Market liberalization of the European country/states will enable the bankers and multinationals to loot Old Europe much more efficiently. Spend some time studying recent “patent reform” in Europe which is blatantly against the interests of most Europeans; consider that the whole point of Europe’s economic union is to unify regulations, providing fertile soil for multinationals; and you will begin to understand that Europe is being Set Up just as America was set up in the 80’s.

    Asia’s next, and sooner than you think. Bear in mind that the necessary exponential growth of capital (interest!) requires ever faster churning of markets to get the elite the return on investment they require. We’re approaching a financial singularity and I don’t think you’re going to like what’s on the other side.

  17. ps

    shah8, your suggested scenario has a very nice fit to the facts. We’ll have to watch to see how the bailout money flows – if they let us.

    You characterize Ponzi scams as stable. Seems to me they are always dependent on new money flowing in and not sustainable.

  18. Anonymous

    Obviously, whomever was collecting the commissions and fees on the initial investments were the perpetrators.

    Like ratings agencies, “Looks good to us, here’s the triple A + stamp, now pay the cost of review.” Not much is said when paper is downgraded by the same who said buy it.

    When a fund is outperforming the normal market growth you can rest assured it is at risk. There has to be a big loser(s) on the other end.

    Greed doesn’t need to see the books until the monthly statement is in the red. That’s why Ponzi schemes always work.

  19. Anonymous

    UBS seeks to deny duty over Madoff funds

    By James Mackintosh in London, Peggy Hollinger in Paris and Haig Simonian in Zurich

    UBS sought to absolve itself from any duty to safeguard investor assets in a $1.4bn fund that channelled money into Bernard Madoff’s alleged $50bn Ponzi scheme.

    The Swiss bank used an agreement that denied it was responsible for the assets – even though its marketing documents claimed it would be.

  20. kevin de bruxelles

    “L’affaire” is the commonly used French equivalent of “case” or “scandal” in English. In French, using the term “L’affaire” certainly has no connotation to the L’affaire Dreyfus–which was just one of any number of “affaires” that have occurred in the past. Yves often uses French phrases in her blog; it seems perfectly natural that she would use the term “L’affaire Madoff”.

    But in any case what would be the issue if she were making reference to the Dreyfus case?

  21. Anonymous

    If I were Bernie, Hail King of the Goniffs, I would be at home on my laptop moving my ill gotten gains around with my numbered accounts. Make it disappear until I pop out of the slammer in a few years!

    Bernie, drink two bottles of Tylenol tonight. Don’t call in the morning.


    This joker and his sons are guilty and many others. I don’t believe that a scam this large could have been pulled off by one guy. It’s crazy.

    He gets to stay in his apartment. Well, isn’t that nice. Gives him a lot of time to do more damage. They should lock him up!

  23. Dimezzano

    “Affaire” Madoff … Where has the money gone ??? …

    have a look at CLEARSTREAM, SWIFT,EUROCLEAR, BRI Basel.

    “Clearstream : compte U0646 BERNARD L. MADOFF”

    “Swift : number MADLGB21”

    “BRI : 760 GB MADOFF SECURITIES INT LTD MADLGB21, Client de Clearstream compte U0646 BERNARD L. MADOFF 0 N DTC646”

    “pour l’argent envolé, voyez chez Clearstream”

  24. Anonymous

    I, too, find it amusing that the same media juggernaut which spins tales about small armies of highly trained men assembling to rob banks or casinos will now have us believe that ONE OLD MAN orchestrated a multi-decade, $50 billion takedown.

    Madoff was the “face”, the guy front running the con, and I’m sure he could handle that role all by himself. But all the other stuff that goes into stealing $50 billion? You don’t pull that off without lots and lots of help. It simply doesn’t happen that way.

    The timing of his confession helped ensure that the furor would be muted by the white noise surrounding the holiday season. I bet more Americans know about the shoe-throwing incident than the Madoff scandal.

    It’s another obvious quasigovernmental scam / cover-up which will be soon be wiped from Americans’ minds by an even bigger scandal. The average guy on the street probably isn’t thinking much about all this except, “Those fucking crooks…”

  25. Steve

    @ ps: Dimezzano appears to be referring to a report on the French site Rue89 that Madoff had an account, either in his own name or a business name, with the Luxemburg clearing house Clearstream. Clearstream is well known to the French public owing to a political scandal that’s been going on for several years. The French are also quite aware of Luxemburg’s banking secrecy laws. Which together make for a wonderful speculative story about where Madoff stashed the loot. Maybe Rue89 has discovered something, but I’m not sure its writer understands the difference between a securities clearing account and a secret bank account. It could simply be a settlement account for trading on European bourses by Madoff’s London operation.

  26. Anonymous

    In Ponzi schemes, the older customers are the ones who make the money. If someone gave Madoff $1 million in 1970 then made 10% every year, he got his original million back in 10 years and everything after that was profit.

    It also appears that there were feeders feeding the Madoff machine who were taking from the profits, etc.

    This one is going to be fun to watch but I don’t believe this is the last Ponzi style scheme we’re going to see in the near future…

  27. Sundar

    I hope he does access secret accts so that IRS and FBI can trace it’s destination!

    why didn’t he pretend like other Hedgies and declare freeze on with drawls keep his ‘consistent’ pay out? This would give some additional years to screw his sophisticated Investors1


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