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Funds of Funds Will Stress Independence and Technology to Avoid the Next Madoff Scandal

After losing billions of dollars in Bernard Madoff's alleged fraud, funds of funds are refocusing on technology to perform due diligence on hedge fund investments.

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.

James Freeman, Senior Relationship Manager, Key Asset Management, London
James Freeman, Senior Relationship Manager, Key Asset Management, London
"The major red flags were to do with predominantly back-office issues," adds James Freeman, senior relationship manager at Key Asset Management, a London-based fund of funds manager with $2 billion in assets invested in 90 underlying hedge funds. "A bad investment process can lose you lots of money, but a [bad] back-office business structure can lose you all of it," he warns.

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.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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