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Hedge Funds: Lessons from Bernie Madoff

By: Jason Whitby

By: Jason Whitby, CFA, CFP®, AIF®

A few months back, a friend told me, “My cousin’s husband’s mother has been investing for over ten years in a hedge fund managed by Bernie Madoff. On average, she is up over 10% a year and never once lost money. Matter of fact, Bernie sold everything in her account this past September right before the big crash. I saw the statements and it looks legitimate. I don’t know how he does it but obviously there are people that can ‘time the market’.” True story, really.

Now if you saw the movie Charlie Wilson’s War, you know the story of the Zen master and the little boy. One day a little boy got a horse for his birthday. “How wonderful,” the entire village said. “We’ll see,” said the Zen master. Time passed and the boy was thrown from the horse and broke his leg. “How horrible,” all the villagers said. “We’ll see,” said the Zen master. Then a war breaks out and all the young men have to go except the boy, whose leg never healed. “How lucky,” all the villagers said. “We’ll see,” said the Zen master. “We’ll see”, it’s my new favorite phrase.

That conversation about Bernard Madoff’s ability to “time the market” was about two months ago, and I’ll admit it was extremely distressing since I believe in a passive investment approach and the person telling me this story is credible. But since then, Bernard was arrested for apparently the greatest Ponzi scheme of all time with a reported loss estimated at $50 billion, though no one is certain just how much money was lost in his hedge funds. It is safe to say that a lot of wealthy individuals and institutions have lost a significant amount of money when you consider that the estimated losses are over twice the $20 billion Auto Industry Bailout Package.

What I keep asking myself is, “What is the main lesson to learn from this?” A lot of attention is being focused on greed and how that affects people’s investment decisions. But it is more than greed; it is also the feeling of being important. Everyone, including me, seems to think on some level that there must be something better. The grass is always greener. We are rarely content with what we have and rarely can just accept the average. This apparently tends to manifest itself to a larger degree with investing and relationships, just check the New York Times Bestseller list. With investing, it is so hard for people to believe that the best way is a passive investment approach, to just accept the market returns. People feel there must be an investment secret, someone knows how. If they could only hire that person and join the inner circle. If only they could join that club, if only they were that important. This idea of an elite group for “VIPs only” has helped fuel the amazing growth of Hedge Fund managers and their promises of actively beating the market. So here are the six main lessons that Bernie might be trying to teach the world. At $50 billion for the lesson, hopefully we will learn something.

VIPs only

Perhaps the deal is for friends and family only. Or someone’s broker has a “way” to get them in. Regardless of how the story unfolds, everyone seems to have someone special that can get them inside. It reminds me of the night clubs with huge lines outside and hardly anyone inside. The bigger the line, the more exclusive the club, the better it must be. Perhaps there is a super elite secret club, so secretive that no one knows about it. More than likely, you are getting sold something and that something is a feeling of being important. Lesson #1: the more exclusive the deal, the more suspicious you should be.

Retail Hedge Funds

Unless you have pretty big bucks to invest, say at least $1 million, you are definitely going to get overrun with fees. A few months back, a friend showed me his statement for Campbell & Co hedge fund. His income was under $50k a year and he had ~$700K total investable assets. Apparently he was important enough to be in the VIP hedge fund club and now didn’t want to get out. Fair enough, but there were so many hands in that cookie jar taking fees that he was never going to get anything special out of this investment. In order for him to get access to the hedge fund, the fund had been packaged and then repackaged and then repackaged again. It isn’t that different from buying direct from the manufacturer versus buying at the local 7 Eleven. Unless you can invest in bulk, you are buying retail. By the time all of the middle men get paid, you are getting charged a lot for something you probably don’t need nor understand. Lesson #2: unless you are big enough to buy direct, any real value the manager might have is lost to fees.

Friendliness nor looks an angel doth make

I can guarantee that there are no successful con men that look like criminals and are really big jerks. People like doing business with people they like. So being friendly is a key part to conning investors and too often is used to hide and distract from what really matters. That is one of the reasons why so much investment fraud occurs at places of worship and social groups. Additionally, a person’s appearance and the ability to sit down and look someone in the eye are overrated. After all, here is a picture of Bernie.

He looks like a clean cut and freshly shaven Santa Clause, not the ultimate conman that swindled $50 billion. So don’t let personal feelings distract you from making good common sense decisions based on facts. Lesson #3: keep it business.

If you do qualify

If you do have significant money to invest and can do your due diligence, it still isn’t likely worth it. Consider that each hedge fund typically charges between 2% and 20% of the profits. If you diversify and use a fund of funds, you add another layer of fees on top of that. Additionally, you need to believe that the manager can beat the market after all of these fees and you need to do it on faith. Hedge funds are extremely secretive and provide little ongoing information. Additionally, you need to agree to restricted access of your money. Essentially you are saying, “Here is my money. You do not need to provide much validation of your work and I will only ask for my money back when you give me permission. Oh yeah, please remember to pay yourself very well.” Lesson #4: the hedge fund business is designed to give very unfavorable terms for the investors.

If they are that good

Before you invest in a hedge fund, you must convince yourself that the manager can beat the market consistently over time; otherwise why give him your money? But if the manager can, why does he need your money? Once upon a time, I did have a client that was that good. He had developed a trading algorithm that had been making money on a small scale, consistently for years. Needless to say he was keeping it all to himself. After all, why invite you to his party? After a few more years, the system wasn’t working as well since other investors started to catch on. That was when he got out and sold it to someone that planned to start a hedge fund. Lesson #5: anyone that can truly beat the market doesn’t need investor’s money and isn’t going to share in the profits.

Watch out for all the experts

At Investor Solutions, we don’t give much thought to selecting active investment managers, but a lot of firms specialize in this very area. Right now they all seem to be claiming to have known Bernie was a fraud. It’s amazing Bernie had any investors at all given so many of these “experts” apparently were on to him. Just last night at a dinner, an investment banker said their hedge fund group had recommended not investing with Bernie. More than likely they just weren’t invited to Bernie’s exclusive club, most institutions weren’t. Regardless, Tremont got taken by Bernie Madoff and they are one of the biggest funds of hedge funds with a ton of really smart people doing all sorts of due diligence. If it can happen to Tremont, it can happen to anyone. Finding an active manager producing alpha is like finding a needle in a haystack by hand, using a metal detector doesn’t count. Lesson #6: doing due diligence on hedge funds is practically impossible.

In a short time from now, I image that all of the lessons from Bernie Madoff will be forgotten, just as Long-Term Capital was forgotten, just as Bayou Funds was forgotten. The investment landscape is littered with the corpses of dead hedge funds. Soon some other secret manager for the elite will come forward to take Bernie’s place with the promise of easy money. But for me, I’m thrilled to be a passive investor. I’m so glad I was never invited to join Bernie’s club. It would have been a very tempting offer. And I would have felt so important to be in that exclusive group even though I would have always known that I didn’t belong. Perhaps it is wrong to take comfort in Bernie’s $50 billion lesson. But my understanding of how the investment world works has been completely restored. A passive investment strategy has once again shown to be more prudent than active and hedge funds are proving to be highly overrated. But then again, I suppose “we’ll see.”