Some investors in the Ponzi scheme perpetrated by Bernard Madoff Investment Securities, the broker-dealer founded by the ex-Nasdaq chairman, knew that he was cheating – and that’s why they invested. That is the disturbing conclusion of commentators familiar with the strategy and its feeder funds.
“A lot of people either saw or got a sense that something was fishy, but thought, ‘He’s probably front-running – but he’s front-running for me’,” said Jacob Schmidt, CEO of hedge fund advisory firm Schmidt Research Partners, who steered his clients clear after he did due diligence on Madoff feeders in 2003. “What kind of attitude is that? I can understand that a private individual might like that idea, but I cannot accept that from institutional investors.”
According to public sources and investor database MandateWire, European asset owners caught up in the scam include the Merseyside and Hampshire Pension Funds; Italy’s Unicredito and Deutsche Bank Italia Pension Funds; Danish and Dutch giants PFA Pension and the Shell Pension Fund; and Switzerland’s St. Galler Kantonalbank.
They will hope the worst their intermediaries can be accused of is incompetence. Bramdean Asset Management, which advised the Merseyside and Hampshire money, professed itself “deeply shocked”, passing the buck onto its advisor, RMF, and regulators. Private bank Reichmuth & Co told clients, including the St. Galler bank, “no one is immune against fraud”. Fairfield Greenwich, a firm of 25 years’ experience which handled many of the other allocations, said it shared clients’ “shock and dismay” – almost half its assets under management was with Mr Madoff. UBP, the world’s second-biggest hedge-fund investor with a well-respected due diligence team, channelled $700m of client’s cash into Madoff feeders.
Are there any excuses? UBP said it would no longer invest with self-administered or self-audited funds. The history of the industry means that that set-up is not unusual in the US.
“The move to independent administrators has been in the offing for a long time,” says Hans Hufschmid, CEO of GlobeOp. “Now investors are looking at self-administration and saying, ‘I just cannot afford to take that risk.’”
A simple name on a prospectus is no guarantee that administrators are not merely printing-out investor-statements at month-end: most administration contracts still allow service providers to source pricing from managers, and only full administration involves reconciling cash, trades and positions truly independently – preventing frauds which involve no trading at all.
Furthermore, much of the due diligence effort focused on feeders – generally independently-administered and Big-Four audited – rather than the underlying brokerage account with Madoff Securities itself, so at a stretch we might say that the independent-admin issue was not a clear-cut red flag.
But, as Mr Schmidt says, it was only one of many: “The call for everything to be independent is silly. Those calling for this should look at their own mistakes.”
The feeders had stock and option certificates which looked genuine to Mr Schmidt: there was no independent check on this, but feeder-level service providers accepted them as such. But offices were fortress-like, and when he finally got in he saw bizarre behaviour: he was forbidden to make photocopies and staff got “very unhappy” when he tried to take notes.
“I didn’t understand it - there was nothing unusual about the statements,” he recalls.
Managers with complex proprietary black-boxes worry about reverse-engineering, but Madoff’s strategy was simple - timing moves from US Treasuries into the S&P100 (hedged with a split-strike collar).
To return 10 per cent a year with such freakishly-low volatility he would have to be “the best trader ever,” as Mr Schmidt puts it, and there were those suspicious enough to try and model his historical returns. Markov Processes International ran the numbers in 2006, and the only asset they found correlated with Madoff was the Bayou Fund – which started creating false returns after its real strategy went south in 1998. UBP told its investors that Madoff’s “perceived edge” was his order-flow knowledge as major broker/dealer – but surely if there were any doubt concerning the audit and admin regime, the secrecy and the uncanny returns, due diligence would have followed-up with this quant analysis?
And there was definitely doubt. UBP told investors that it identified non-segregation of investment, brokerage and custody functions as a risk but “found comfort” in Madoff’s status as a “reputable broker/dealer subject to routine SEC and Finra regulatory audits”. The Wall Street Journal claims to have seen emails from then-deputy head of research, Gideon Nieuwoudt, listing concerns. Amber Partners, a hedge fund rating agency now suggests that the non-segregation issues, the lack of a Big Four auditor, the refusal to provide clients with electronic access to accounts (and physical access to offices) were all red flags.
“I can’t believe that these institutions don’t have the expertise,” says Jérôme de Lavenère Lussan, managing partner at hedge fund due diligence consultant Laven Partners. “I believe it’s a matter of negligence – they misled themselves.”
For some, the Sharpe-ratio boost of a 10-20 per cent allocation to such stable returns may have been temptation enough to ignore the signs. Rigorous due diligence often is not seen to pay off for years, and in the meantime it can be difficult to explain why clients cannot have a piece of such a great manager. And none of the feeder funds – which charged 2-and-20 and only paid brokerage fees for their Madoff accounts – probed too deeply into why a manager would give away this terrific alpha for free.
“The guy’s making 12 per cent a year and you’re getting paid 2 and 20 on it,” says Mr Lussan. “You’re not going to ask too many questions, are you? That’s a problem across the entire asset management industry.”
