Fund of Funds Pass the Buck and Lose It For Their Clients

by Jacob Zamansky on December 18th, 2008 at 12:24 pm : Comments 000

“If it sounds too good to be true…It probably is.”

We’re hearing this phrase repeatedly with regard to Bernie Madoff’s alleged Ponzi scheme.   Under a cloak of secrecy, Madoff’s funds reportedly delivered handsome returns year after year regardless of market volatility.  To the best of my knowledge, only the Treasury Department can print money, but apparently that fact was lost on a great many of so-called “sophisticated” investors.

Retirees and smaller investors deserve a pass (and their money back) for falling victim to Madoff’s reported schemes.  Even if the returns were unbelievable, they didn’t have a frame of reference to make a complete judgment.  After all, Mr. Madoff was a respected member of several wealthy communities and donated large amounts of money to various charities. On the surface he appeared to be a Wall Street legend.  By the same token, if any reasonable amount of due diligence had been performed, the red flags were out in the open.  From his secret formula, to outsized returns and even a one-room auditing firm, there were plenty of reasons to be suspicious of Mr. Madoff.  And indeed, many were and chose to invest elsewhere.

Which is why, as we all shake our heads at the clear signs of fraud, we should be shaking our fingers at the managers of the feeder funds who ignorantly - perhaps even fraudulently - invested huge percentages of their assets under management with Bernie Madoff.  It is the fund of funds manager whose job it is to be on the look out for warning signs of potential fraud risks.  They have a fiduciary responsibility, and are paid handsomely, to make suitable investment decisions for their clients.  They were paid to have the frame of reference individual investors cannot possibly have.

Fund-of-funds exist to seek out and vet the very best - and safest - money managers.  They are also expected to diversify so that in case of a large collapse, the damage is mitigated.  They are usually paid 1 to 1.5 percent of total assets under management as well as a hefty chunk of the returns.  One of the fund-of-funds that had significant exposure to Madoff Securities is Ascot Partners, managed by J. Ezra Merkin.  He has reportedly lost $1.8 billion of his client’s money. According the New York Times, Mr. Merkin took just three paragraphs to explain his losses to clients; this compared to a fifty-four page offering memo.

Ascot, as well as other feeder funds such as Fairfield Greenwich, Tremont and Maxam Capital Management could have significant liability for their losses if in fact their firms did not perform a reasonable amount of due diligence for which they were paid. Through this negligence, they may have empowered Mr. Madoff to pull of what many are saying is the scam of the century.

In addition to negligence, it’s likely that there are disclosure issues at stake. Fund-of-fund investors likely had no idea such a huge percentage of their money was under Mr. Madoff’s control - or any single money manager for that matter.  Huge concentrations like this are indicative of “style drift,” which occurs when a manager diverges from the original strategy promised to investors…usually because of large losses.

For these reasons and the impending litigation, the fund-of-funds industry has been dealt a huge blow.   It was redemption requests that led to Bernie Madoff’s undoing.  I certainly hope he’s an exception to the norm, but I have my doubts.

Filed under Hedge Funds, Investment Fraud, Securities Arbitration, Wall Street
and Bernie Madoff, Fund of funds, Investment Fraud, madoff exposure