Funds of Funds Will Stress Independence and Technology to Avoid the Next Madoff Scandal Jan 29, 2009 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=212903239
See Related Article: What Is a Fund Administrator?
As federal prosecutors and regulators continue to probe the alleged $50 billion Ponzi scheme run by Wall Street market maker Bernard Madoff, the losses are causing a shakeout in the fund of funds industry. Amid the turmoil, questions are being raised about the investment practices of funds of funds that may have ignored the red flags that surrounded the accused financier's investment advisory operations. Industry sources suspect there was a lack of due diligence on the part of some of the larger funds of funds and private banks that pumped money into Madoff's black-box trading strategies.
"The failure of the funds of funds that invested with Madoff was simply that they didn't do the due diligence that they ought to have done," says Rich Koppel, managing director at youDevise Ltd., a supplier of hedge fund technology that has offices in London, New York and Hong Kong.
Second, the fund of funds should have technology that gathers information on various hedge funds, including a compliance system that checks the values of the portfolios of hedge funds against internal restrictions and a database that monitors the performance of these funds against their peers. Third, a fund of funds should require traders or hedge funds to employ independent fund administrators whose job is to calculate the net asset value of the fund and reconcile the positions with the clearing broker, custodian or prime broker.
Too Good to Be True
In Madoff's case, there were plenty of warning signs, and in fact many funds of funds passed on investing with him. Jeffrey Vale, director of hedge fund strategies at Infinity Capital Partners, a fund of funds in Atlanta, for example, rejected investing with Madoff based largely on the secrecy of Madoff's operations. "It was kind of this guy behind the black curtain running things," relates Vale. "Nobody had good enough access to him to verify the numbers, and there was no third-party administrator.
"From where I sit in the fund-of-funds side, I've looked at [Madoff's] return stream several times and rejected it [based] on my gut," Vale adds. "It's checks and balances -- you have to check all the boxes."
Among the most glaring red flags, according to Vale, were the facts that Madoff was self-clearing and that his own broker-dealer, Bernard L. Madoff Investment Securities, served as the custodian for his investment advisory business. "Madoff cleared all of his [own] trades. It's a huge conflict of interest for a firm running money for others [to be] running trades and clearing through their own broker-dealer," asserts Vale, who allocates about $300 million in assets across 12 large multi-strategy hedge funds. "They need to be clearing their trades through other firms. That makes the trade a real trade because you're doing a transaction with a third party" that can verify the trade.
Another issue was the quality of Madoff's auditor, a two-person firm based in upstate New York. Funds of funds usually require brand-name accounting firms, says Vale, who notes that his firm could never get a straight answer on which firm was auditing Madoff's books. (Only after Madoff was arrested on Dec. 11, 2008, and news of the alleged fraud became public was the name of the auditing firm revealed.)
Despite the obvious warning signs, many funds of funds -- including Fairfield Greenwich's Fairfield Sentry; Tremont Capital's Rye Investment Group; and Banco Santander's Optimal Investment Services, which had exposure to Madoff through its Optimal Strategic U.S. Equity hedge fund -- invested millions with Madoff. Even Geneva-based Union Bancaire Privee (UBP), one of the world's largest investors in hedge funds, placed $700 million of investors' money with Madoff, according to the investment bank.
UBP invested in four Madoff vehicles: Ascot Fund, Fairfield Sentry, Kingate Euro Fund and M-Invest. While three of these vehicles employed brand-name fund administrators and auditors -- for instance, M-Invest was administered by Citco Fund Services (Bermuda) and audited by Ernst & Young (Cayman Islands) -- the fourth, Ascot, was self-administered by Ezra Merkin, meaning that Merkin's investment firm valued the Ascot fund on its own. Nonetheless, it's not clear how much due diligence UBP and other feeder funds did on their own.
A 'Deal Killer'
Infinity Capital's Vale speculates that the feeder funds "depended on the numbers that [Madoff's] underlying funds provided." Even though some of the underlying funds had third-party fund administrators, even the third-party administrators appear to have accepted Madoff's numbers. "Madoff was providing those numbers. Nobody dug a little bit deeper to see that those numbers were just coming from in-house," Vale claims.
"There was no third-party firm at all looking at the numbers to verify even if they were real or correct," Vale continues. "That's a deal killer for us."
Now these third-party administrators and auditing firms are under scrutiny and, in some cases, are the targets of lawsuits.
According to Thomas Davis, president and CEO of Meridian Fund Services, the fund administrators should have been checking the brokerage statements that Madoff's firm was producing with the clearing broker. Since Madoff's firm was the clearing broker, the fund administrators should have asked harder questions. As a result of their failure to do so, Davis suggests, they now will be asked: "Why weren't you checking all the transactions that came through? Why did you accept statements that were coming from a brokerage company owned by the investment adviser? Why did you accept such important information that he controlled?"
In general, fund administrators and fund of funds sources agree there was a general lack of independence between Madoff's money management operations and his family-owned broker-dealer operations. "There was very little independence in this thing. A huge red flag was that everybody was housed in the same environment," says Michael Griffin, executive chairman of Spectrum Global Fund Administration in Chicago.
The first red flag, Freeman says, was the reporting mechanism among Madoff's investment advisory firm, the feeder funds' administrators, and the pricing and policy entity. How was that information reconciled among the various independent parties, and did that reconciliation occur over a secure electronic communications network? "If a trader was a fabricator, where it would be detected is in the interaction between the prime broker, the fund administrator and the fund itself," Freeman asserts.
"All the major classic frauds -- Beacon Hill Asset Management and the Manhattan Fund -- use that tactic, [in which] the broker is the sole source of the quote [aka, net asset value] and it's not being reconciled by a third-party administrator, to send out false information because there is no record of it and you have no independent validation if the information is correct," says Freeman.
Trading Without Transparency
On the trading side, according to Freeman, a number of high-profile banks and several funds of funds that were caught in the Madoff fraud ignored due diligence from a quantitative perspective. The options strategy outlined by Madoff, Freeman contends, simply was not capable of generating the returns that he was reporting. Freeman explains that the liquidity in the options contracts Madoff claimed to use, Standard & Poor's 100 Index contracts, could not support the $17 billion in assets that he claimed to have under management.
"If you cannot get transparency, [and] no one will show you the portfolio even on a site visit, that is a red flag," says Freeman. "If you cannot talk to anyone other than his family, that is a major red flag to investors."
According to Infinity Capital's Vale, the only data Madoff provided was a historical report of positions. But, "You could never verify that," he points out. "It was coming from the broker-dealer."
So how could the funds of funds not delve deeper into Madoff's trading positions? "I find it staggering that larger funds did not conduct that exercise," Key Asset Management's Freeman says.
But, he admits, it is difficult to re-create a fund's trading positions. Often, "That does have to be taken on trust," says Freeman, who notes that a particular quantitative manager may have as many as 1,000 positions, and the turnover tends to be high. "Even if we had the information," he concedes, "it would be problematic to manage it."
As part of the due diligence process at Key Asset Management, Freeman relates, qualitative and quantitative checks occur on a separate database. "We can see our exposure to a particular prime broker or to a particular asset class and leverage in a separate database, which tracks all the personnel involved in any of the funds, all of the prime brokers, all of the meetings, all the legal documentation," he says. But, Freeman points out, Key's back office has a level of complexity that is far greater than that of a long-only fund. He notes that the fund of funds currently is invested with 90 hedge funds through seven products, each of which is invested in 15 to 30 hedge funds.
Technology to the Rescue
Clearly there were enough warning signs to dictate further investigation into Madoff's operations. But would technology have helped the funds of funds uncover the fraudulent returns or perhaps raise enough doubts to have caused them to avoid investing with Madoff in the first place?
YouDevise's Koppel argues that simple due diligence supported by technology could have helped funds of funds avoid the Madoff mess altogether. "Lack of technology or failure to use technology effectively is a factor," says Koppel, who helped develop a portfolio management system called Hedge Fund Information Provider (HIP) that is currently used by hedge funds and funds of funds in North America and Europe. "Although technology by itself doesn't perform due diligence, it enforces a certain discipline that ensures you do the due diligence."
The funds of funds, Koppel continues, should have been performing due diligence on an ongoing basis, including speaking to the hedge fund managers. But conducting due diligence is not an easy task, he acknowledges. Funds of funds typically manage investments in as many as 50 hedge funds and might be tracking another 50 to 100 funds. Some conduct research at the desk, and others make on-site visits. "Having a [CRM] system that collates the information that you get from various sources is very helpful," says Koppel. "They should be doing this in a rigorous way when they're contemplating making an investment."
Even seemingly mundane information, such as a brief conversation with a hedge fund manager, could trigger a concern, Koppel adds. If this information is captured by a system as part of the due diligence process, other people may pick up on it, he suggests.
In addition, funds of funds should leverage front-office statistical packages that measure how a fund performs, often against averages, providing another way to uncover red flags, advises Koppel. Technology, he explains, can help funds of funds analyze the source of a hedge fund's performance, taking into consideration investment strategies, such as long/short equity or arbitrage, and geographic regions. For example, if a hedge fund claims 10 percent returns, and 3 percent of those returns originate with a long/short equities strategy, where does the remaining 7 percent return originate?
Further, funds of funds should "establish internal compliance guidelines regarding the investment they want to make or the portfolios they want to assemble," Koppel stresses. They should continually check their own portfolios as the values of the underlying hedge fund investments change to see if the funds of funds' portfolios remain in compliance with the established guidelines, he adds. For example, Koppel says, a fund of funds may not want more than 20 percent of its portfolio in long/short equity funds.
A Call for Independence
While funds of funds may be forced to recognize their own culpability in the Madoff scandal, efforts to prevent such fraud in the future are likely to focus on the role of third-party fund administrators, according to sources. Already institutional investors that lost money with Madoff are putting pressure on major hedge funds to appoint independent fund administrators.
"I expect an increasing emphasis in 2009 on infrastructure and service providers to be pronounced, particularly on the use of independent fund administrators," confirms Kenneth Heinz, president of Chicago-based Hedge Fund Research, who says there will be particular scrutiny of the independence of the service providers. "If you were to identify what was structurally going on, what would have mitigated some of this risk, it [would be] the use of independent administrators."
According to The Wall Street Journal, several leading hedge funds -- including Caxton, D.E. Shaw, SAC Global and Renaissance Technologies -- administer their own funds and in fact invested millions building their own infrastructures for pricing. Initially the hedge funds had to price their own instruments because they were very complex and outside fund administrators lacked the expertise to handle them. But now that has changed.
In January Millennium Management, a $11.5 billion hedge fund manager run by Israel Englander, set an example for the industry when it announced that it had outsourced fund administration to GlobeOp Financial Services. "With everything that's gone on in the world, people wanted more reassurance that everything was proper," says an industry source who spoke on the condition of anonymity.
As a multi-strategy fund manager, Millennium -- which had been conducting independent price verification through GlobeOp for the past few years -- runs a 24-hour trading shop and has significant investments in technology and infrastructure, according to the source. In addition, Millennium has its own internal audit group as well as a OQ1 operational rating by Moody's. "While Millennium continually strives to further improve controls, it was answering to requests from investors," explains the source. "It was just an added layer of assurance."
That added assurance provided by a third-party administrator will only become increasingly important. For example, The Wall Street Journal reported that UBP, which was one of Madoff's largest clients, is requiring all of its hedge fund managers to have a fund administrator. "They got burned, and they just want the insurance of a third party viewing the portfolios," says Infinity Capital's Vale.
Going forward, Spectrum's Griffin predicts, institutions are going to demand more transparency and some level of disclosure on a daily basis from the underlying hedge funds. The way to avoid a Madoff-type situation, he says, is for hedge funds to provide more-frequent reporting and transparency. "They're going to probably want to go to weekly or daily" net asset values, he speculates. "Investors are going to demand there be some degree of independence, more transparency and more-frequent reporting cycles, and a better appreciation of the risk they're taking on."