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.