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Monday, 23 February 2009
Blame flimsy regulation for many fund scams
Hedge fund managers often argue against too much disclosure, because they say it makes it difficult to execute specialised strategies. That may be, but transparency also makes it much tougher to perpetrate scams.
Investors who were shell-shocked by the market’s heavy losses got an additional unpleasant surprise in the final month of last year: the Bernard Madoff scandal.
Madoff ran a US$50 billion investment fund with an exclusive reputation, but the whole thing turned out to be one massive Ponzi scheme in which existing investors’ returns came out of the money contributed by new investors.
Now that all the money is gone, lots of people who thought their investments were safely earning 10 to 12 per cent a year are left with nothing.
This fiasco has caused a lot of soul-searching, not just among people who lost money to Madoff, but also among ordinary investors, who are wondering if they could fall victim to a similar scam. That is a natural reaction, but while it is important to be cautious and do your homework, it is also important not to extrapolate too much from the Madoff scandal. Ordinary mutual fund investors, in fact, are protected in many ways that make a mutual fund version of Madoff very unlikely.
One of the things that allowed Madoff to get away with his scam for so long was the almost total lack of transparency in his business. Like a lot of hedge fund managers, Madoff refused to provide details about his strategy, which supposedly used a combination of blue-chip stocks and options to generate double-digit returns.
For years, various critics questioned whether this strategy was capable of generating such returns. In 2005, the most persistent of such critics, Harry Markopolos, detailed his concerns in a report to the US Securities and Exchange Commission called “The World’s Largest Hedge Fund is a Fraud”. But because hedge funds are not required to disclose very much, these critics could not prove anything, and Madoff was always able to come up with excuses. Nobody even knew exactly how much money Madoff was running, let alone where he had invested it.
Such a lack of transparency has the potential to lead to lots of other problems in the hedge fund industry, beyond the actual problems caused by Madoff. Finance experts Dean Foster and Peyton Young have written a paper called “The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics”, in which they show how easy it would be to use options to “piggyback” and mimic the returns of any fund over time with virtually no effort, but with a small probability that the piggybacking fund would lose all its value.
Given the lack of transparency in the hedge fund industry, somebody could theoretically start a hedge fund using this method to beat the market each year and gather lots of assets; such a fund would be indistinguishable from a true market-beating hedge fund, at least until it blew up and lost everything.
One reason that hedge funds are so lightly regulated is that they’re marketed to wealthy, sophisticated investors who understand and can handle the risks involved. But as the Madoff case shows, such investors can be fleeced by someone who knows a little psychology.
By all accounts, Madoff used the secrecy surrounding his fund to build an aura of prestige and exclusivity, so that many of his victims felt privileged to be allowed to invest with him and did not ask too many questions. Many of his investors also came from the Jewish community, and they trusted him as one of their own. Such brazen deception would be much more difficult to pull off with a mutual fund. US mutual funds are required to disclose their portfolio holdings at least once a quarter, along with expenses and the names of their largest shareholders. Mutual funds available for sale in Hong Kong have looser requirements than in the US.
Each mutual fund is also overseen by a board, whose job it is to look out for shareholders and make sure nothing untoward is going on.
None of this is meant to minimise the importance of the mutual fund scandals, which involved major breaches of trust between many fund companies and their shareholders. In the wake of the scandals, Morningstar launched its mutual fund Stewardship Grades, which are designed to measure how shareholder-friendly funds are, including any regulatory issues.
Hedge fund managers often argue against too much disclosure, because they say it makes it difficult to execute specialised strategies. That may be, but transparency also makes it much tougher to perpetrate scams.
David Kathman is a Morningstar fund analyst based in the US
1 comment:
Blame flimsy regulation for many fund scams
David Kathman
22 February 2009
Investors who were shell-shocked by the market’s heavy losses got an additional unpleasant surprise in the final month of last year: the Bernard Madoff scandal.
Madoff ran a US$50 billion investment fund with an exclusive reputation, but the whole thing turned out to be one massive Ponzi scheme in which existing investors’ returns came out of the money contributed by new investors.
Now that all the money is gone, lots of people who thought their investments were safely earning 10 to 12 per cent a year are left with nothing.
This fiasco has caused a lot of soul-searching, not just among people who lost money to Madoff, but also among ordinary investors, who are wondering if they could fall victim to a similar scam. That is a natural reaction, but while it is important to be cautious and do your homework, it is also important not to extrapolate too much from the Madoff scandal. Ordinary mutual fund investors, in fact, are protected in many ways that make a mutual fund version of Madoff very unlikely.
One of the things that allowed Madoff to get away with his scam for so long was the almost total lack of transparency in his business. Like a lot of hedge fund managers, Madoff refused to provide details about his strategy, which supposedly used a combination of blue-chip stocks and options to generate double-digit returns.
For years, various critics questioned whether this strategy was capable of generating such returns. In 2005, the most persistent of such critics, Harry Markopolos, detailed his concerns in a report to the US Securities and Exchange Commission called “The World’s Largest Hedge Fund is a Fraud”. But because hedge funds are not required to disclose very much, these critics could not prove anything, and Madoff was always able to come up with excuses. Nobody even knew exactly how much money Madoff was running, let alone where he had invested it.
Such a lack of transparency has the potential to lead to lots of other problems in the hedge fund industry, beyond the actual problems caused by Madoff. Finance experts Dean Foster and Peyton Young have written a paper called “The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics”, in which they show how easy it would be to use options to “piggyback” and mimic the returns of any fund over time with virtually no effort, but with a small probability that the piggybacking fund would lose all its value.
Given the lack of transparency in the hedge fund industry, somebody could theoretically start a hedge fund using this method to beat the market each year and gather lots of assets; such a fund would be indistinguishable from a true market-beating hedge fund, at least until it blew up and lost everything.
One reason that hedge funds are so lightly regulated is that they’re marketed to wealthy, sophisticated investors who understand and can handle the risks involved. But as the Madoff case shows, such investors can be fleeced by someone who knows a little psychology.
By all accounts, Madoff used the secrecy surrounding his fund to build an aura of prestige and exclusivity, so that many of his victims felt privileged to be allowed to invest with him and did not ask too many questions. Many of his investors also came from the Jewish community, and they trusted him as one of their own. Such brazen deception would be much more difficult to pull off with a mutual fund. US mutual funds are required to disclose their portfolio holdings at least once a quarter, along with expenses and the names of their largest shareholders. Mutual funds available for sale in Hong Kong have looser requirements than in the US.
Each mutual fund is also overseen by a board, whose job it is to look out for shareholders and make sure nothing untoward is going on.
None of this is meant to minimise the importance of the mutual fund scandals, which involved major breaches of trust between many fund companies and their shareholders. In the wake of the scandals, Morningstar launched its mutual fund Stewardship Grades, which are designed to measure how shareholder-friendly funds are, including any regulatory issues.
Hedge fund managers often argue against too much disclosure, because they say it makes it difficult to execute specialised strategies. That may be, but transparency also makes it much tougher to perpetrate scams.
David Kathman is a Morningstar fund analyst based in the US
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