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.

See Related Article: What Is a Fund Administrator?

As federal prosecutors and regulators continue to probe the alleged $50 billion Ponzi scheme run by Wall Street market maker Bernard Madoff, the losses are causing a shakeout in the fund of funds industry. Amid the turmoil, questions are being raised about the investment practices of funds of funds that may have ignored the red flags that surrounded the accused financier's investment advisory operations. Industry sources suspect there was a lack of due diligence on the part of some of the larger funds of funds and private banks that pumped money into Madoff's black-box trading strategies.

With his track record of steady but unspectacular returns, his aura of exclusivity, and his past role as chairman of the Nasdaq Stock Market, Madoff had access to an international network of funds of funds that funneled assets into his trading strategies via offshore fund vehicles. While several of these funds of funds, or so-called "feeder funds," have portrayed themselves as victims of the Madoff fraud, many observers question what systems they used to track or analyze the performance of his trading strategies, and whether they performed any due diligence at all.

"The failure of the funds of funds that invested with Madoff was simply that they didn't do the due diligence that they ought to have done," says Rich Koppel, managing director at youDevise Ltd., a supplier of hedge fund technology that has offices in London, New York and Hong Kong.

Experts say there are three ways that a fund of funds can identify potentially fraudulent hedge funds or trading strategies such as Madoff's. First, a fund of funds needs to examine the operations of the hedge fund and make certain there are no conflicts of interest, such as the hedge fund manager owning the broker-dealer that clears its trades. A third-party clearing broker or prime broker should be utilized to verify trades, and other checks and balances, such as a brand-name auditor, should be in place.

Second, the fund of funds should have technology that gathers information on various hedge funds, including a compliance system that checks the values of the portfolios of hedge funds against internal restrictions and a database that monitors the performance of these funds against their peers. Third, a fund of funds should require traders or hedge funds to employ independent fund administrators whose job is to calculate the net asset value of the fund and reconcile the positions with the clearing broker, custodian or prime broker.

Too Good to Be True

In Madoff's case, there were plenty of warning signs, and in fact many funds of funds passed on investing with him. Jeffrey Vale, director of hedge fund strategies at Infinity Capital Partners, a fund of funds in Atlanta, for example, rejected investing with Madoff based largely on the secrecy of Madoff's operations. "It was kind of this guy behind the black curtain running things," relates Vale. "Nobody had good enough access to him to verify the numbers, and there was no third-party administrator.

"From where I sit in the fund-of-funds side, I've looked at [Madoff's] return stream several times and rejected it [based] on my gut," Vale adds. "It's checks and balances -- you have to check all the boxes."

Among the most glaring red flags, according to Vale, were the facts that Madoff was self-clearing and that his own broker-dealer, Bernard L. Madoff Investment Securities, served as the custodian for his investment advisory business. "Madoff cleared all of his [own] trades. It's a huge conflict of interest for a firm running money for others [to be] running trades and clearing through their own broker-dealer," asserts Vale, who allocates about $300 million in assets across 12 large multi-strategy hedge funds. "They need to be clearing their trades through other firms. That makes the trade a real trade because you're doing a transaction with a third party" that can verify the trade.

Another issue was the quality of Madoff's auditor, a two-person firm based in upstate New York. Funds of funds usually require brand-name accounting firms, says Vale, who notes that his firm could never get a straight answer on which firm was auditing Madoff's books. (Only after Madoff was arrested on Dec. 11, 2008, and news of the alleged fraud became public was the name of the auditing firm revealed.)

Despite the obvious warning signs, many funds of funds -- including Fairfield Greenwich's Fairfield Sentry; Tremont Capital's Rye Investment Group; and Banco Santander's Optimal Investment Services, which had exposure to Madoff through its Optimal Strategic U.S. Equity hedge fund -- invested millions with Madoff. Even Geneva-based Union Bancaire Privee (UBP), one of the world's largest investors in hedge funds, placed $700 million of investors' money with Madoff, according to the investment bank.

UBP invested in four Madoff vehicles: Ascot Fund, Fairfield Sentry, Kingate Euro Fund and M-Invest. While three of these vehicles employed brand-name fund administrators and auditors -- for instance, M-Invest was administered by Citco Fund Services (Bermuda) and audited by Ernst & Young (Cayman Islands) -- the fourth, Ascot, was self-administered by Ezra Merkin, meaning that Merkin's investment firm valued the Ascot fund on its own. Nonetheless, it's not clear how much due diligence UBP and other feeder funds did on their own.

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