I’m delighted that Scott Johnston once again allows me to share one of his excellent monthly newsletters. Scott’s an experienced hedge fund exec who’s currently a PM and principal at the Belstar Group, an asset allocator and fund-of-funds. Contact him at sjohnston {AT} belstargroup [DOT] com.

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Dear Partners and Friends,

The Madoff scandal has so many facets, it is difficult to know where to start. The sheer size of it is mind boggling. Many thought that the initial $50 billion number, which came from Madoff himself, was likely an exaggeration, but as of this writing, it may not be. I think back to Ivan Boesky, the singular scammer of the 1980s. I think he managed a few hundred million

Is this a hedge fund scandal? I think you’d have to say that it is, despite the fact that Madoff did not, himself, run a hedge fund. He accepted brokerage accounts, which he then managed through his own brokerage firm. But many formed de facto hedge funds around Madoff for the sole purpose of feeding money to him.

Scammers will always be with us. It should not be shocking to anyone that there are those willing to lie and cheat to make money. Bernie Madoff is simply the latest of a long line of con men: Charles Ponzi, Bernard Cornfeld, Ivan Boesky, Sam Israel, Dana Giachetto, Raffaello Follieri (Anne Hathaway’s boyfriend)…it’s a long list.

Charles Ponzi. Is he smirking?

What’s different here is how large this one got before it folded. What made this possible? Answer: the enablers. These were the large feeder funds set up by others who sold access to the Madoff money machine. What culpability do they have in all this? A lot, me thinks. It comes down to reasonable expectations for due diligence.

I should say that no one is ever going to be 100% immune from the possibility of fraud, including us. But there are two basic lines of inquiry in this business that will keep you out of 90% of the frauds:

1. Who is the auditor? Have you ever heard of them? Do they have other reputable clients? Are they independent of the hedge fund?
2. Who is the prime broker? Are they a recognized name in the industry? Are they independent of the hedge fund?

A weak answer on either of these issues is enough for any smart investor to walk away.

Remember Bayou? They owned their own accounting firm, which made it easy to issue false audits. While cross ownership may have been difficult to uncover, it was a simple matter to determine that the accounting firm, “Richmond Fairfield Associates,” was an unknown entity. Also, Bayou owned its own broker-dealer, through which it did 100% of its trading. This is a problem in two ways. First, you don’t have an independent third party verifying and custodizing the assets. Second, it’s a trading conflict-of-interest. Is the fund getting best execution? Unlikely.

Let’s add to these red flags a yellow flag: overly smooth returns. I say yellow because there are one or two reputable ways to make money that produce fairly stable returns (most of the time), but these are in the lending area, not trading. Any trading strategy that produces month after month of steady returns is a blow-up waiting to happen, either from a shift in markets or because it was just a fraud to begin with. Bayou, naturally, had very smooth returns. The point is, smooth returns should, at a minimum, evoke some very pointed questions about the underlying strategy. My personal recommendation: How the heck do you do that?

How would Madoff have stood up to these questions? Well, Madoff’s auditor, Friehling & Horowitz, is complete unknown. But wait, it gets better. They operate out of a single 13 x 18 foot office located in a strip mall in Rockland County, NY. I looked it up on Google Earth:

They apparently had three employees, one of whom was 80 years old and another was a secretary.

Madoff owned his own broker dealer and charged a commission on every trade. He was, in fact, quite open about it. It was how he said he made all his money. He left the management and 20% incentive fees, incredibly, to the feeders.

Madoff had insanely smooth returns. Here’s what one of the feeder funds looks like:

Only five down months in two decades. Pretty good for a trading strategy, assuming it was possible, which it isn’t. Not even with $1 million, let alone $50 billion.

Which brings me to the feeders. The feeders are the truly remarkable part of the story, since there were a number of them, and the level of negligence is breathtaking.

The largest feeder was the Fairfield Greenwich Group, with about $7.5 billion in Madoff through its Fairfield Sentry Fund. Here’s what it says about due diligence on their website:

FGG’s due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.

A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:

1. Portfolio Evaluation, Investment Performance, and Financial Risks:

A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:

· Examines independent prime broker trading records

· Conducts detailed interviews to better understand the manager’s methodology for forming a market view, and for selecting and exiting core positions

· Analyses trading records

· Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time

· Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events

· Reviews the risk and return factors inherent in the strategy

· Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate’s strategy

· Analyses the various drivers underlying a particular portfolio’s risk

· Evaluates credit risk and market risk both at the instrument and portfolio level

· Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund

· Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security

FGG also conducts many quantitative reviews of investment performance in light of:

· Fees and fee structure

· Historical draw-downs

· Return volatility

· Commissions earned

· Performance return in calm versus volatile markets

· Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks

FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.

Style fidelity is another key area of inquiry; the manager’s trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.

2. Personal Background Investigation:

FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
FGG verifies:
Education
Personal credit standing
Litigation and regulatory background
Track record
Other indicators

FGG explores the manager’s experience and qualifications relative to the strategy being managed. Prior professional associations of a manager’s key personnel can be crucial in understanding a person’s experience and character and how they run their investment management business.

3. Structural and Operational Risk:

“Operational risk” refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events. Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.

Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.

FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.

4. Legal, Compliance, and Regulatory Risk:

FGG’s legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.

Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.

Wow, sure sounds good. No stone left unturned there! Except for the fact that they couldn’t have done any of these things. Clearly, no one ever made the one hour drive from New York to Rockland County to visit “Friehling & Horowitz,” although perhaps they were waylaid by the Dunkin Donuts next door. Frankly, I’m amazed FGG’s website is still up because it’s a plaintiff attorney’s dream.

The true winner of the Bozo the Clown award for Dysfunctional Investing must go to Fred Wilpon. His company, Sterling Stamos, was in both Madoff and Bayou. Ask yourself, wouldn’t the Bayou experience cause you to ask some basic questions about your due diligence process? Wouldn’t you then make a change or two? Maybe? Perhaps the annual collapse of the New York Mets proved too great a distraction.

Lots of people got into this scam because they assumed, with so many seemingly reputable people involved, that someone, somewhere, had done actual due diligence. While in a perfect world everyone does their own homework, the practical matter is that individual investors rely on intermediaries. Those intermediaries failed them horribly and have given the whole industry its greatest black eye ever.

A few other thoughts on this. I find it highly unlikely that Madoff’s sons didn’t know about the scam. This was simply too big an operation for one person to pull off. Think of the paperwork alone. When the writing was on the wall, I think Madoff let his sons turn him in to give them the veneer of innocence. I could be wrong, but I doubt it.

Also, from the return stream, as well as some very early red flags that some investors threw, it was clear this was a scam from the start. In most of the investment scams that I have seen (see my letter from March), the manager starts out honestly but goes awry. At some point he decides to lie in the hopes of making the money back (I’ll do it just this once…). Madoff was a liar and a cheat right from the start.

Lastly, Madoff’s golf game is as suspiciously consistent as his investment returns:

Source: ghin.com

Rest assured we know all of our funds’ accountants and prime brokers. They are all prominent institutions and completely independent of our underlying hedge funds.

On a completely different note, in my next letter I will forward an argument on why we may be entering a golden age for hedge fund returns. If this seems incongruous with everything that’s going on, stay tuned.

- Scott Johnston

]]> http://www.puppetmastertrading.com/blog/2008/12/15/ship-of-fools/feed/ 6 http://www.puppetmastertrading.com/blog/2008/07/14/if/ http://www.puppetmastertrading.com/blog/2008/07/14/if/#comments Mon, 14 Jul 2008 15:26:01 +0000 tito http://www.puppetmastertrading.com/blog-test/?p=69