ponzi

How To Save Yourself From The Next Madoff Ponzi Scheme

“Don’t invest in anything you don’t understand – beware of anything that seems too good to be true and where noone is able to explain to you why it isn’t…”

In the below clip, Smart Money Expert Gemma Godfrey quickly explains how to avoid another Madoff – how a Ponzi scheme works, how to spot one and how to be smarter with your money.

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Hedge Funds – to be Feared or Favoured?

As the biggest hedge fund insider trading case comes to a close, we are reminded of the risks of investing in the asset class. Ever since generating losses in 2008, the reputation of these ‘absolute return’ vehicles has been damaged. The Madoff scandal which topped off the year did not help. Nevertheless, whilst clarity in the markets remains illusive and with a wider range of tools to exploit opportunities, are they a form of investment to be feared or favoured?

A Tainted Asset Class

Disappointed and disillusioned, many investors are reluctant to revisit the asset class run by managers once hailed as the new “masters of the universe”. Sold on the promise of generating positive performance in any market environment or at the very least preserving capital in times of stress, losses generated in 2008 came as a shock. With the Madoff scandal came the realization that even funds that did consistently generate steady returns were not immune to trouble. There is even an aptly named “Hedge Fund Implode-o-Meter” website tracking the number of major funds which have “imploded” since late 2006 (out of interest the number at last look stands at 117, although this includes all funds suffering any form of “permanent adverse change”, not just total shutdown).

But Not All Are Created Equal

Not all hedge funds should be tarred with the same brush and although grouped within the same category, they can differ tremendously. From the investment vehicles in which they invest to the stringency of their risk management, not all are created equal. The Hedge Fund Association summed the situation up succinctly with the assertion that “investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.”

Losses Were Often Greater Elsewhere

Putting aside the often misleading ‘absolute return’ banner, the average hedge fund was better able to preserve capital through the market downturn than a regular ‘long-only’ mutual fund. Whilst the MSCI World Index fell 42% in 2008, the Credit/Suisse Tremont Hedge Fund Index fell 19%, More impressive still were the 21% of funds which posted positive returns for the year (the majority of which were up double digits). Crucially, over a more appropriate investment horizon of 3 years, according to figures by EDHEC Business School, “The majority of hedge funds delivered better returns than the S&P 500 index”. Hedge Funds have shown themselves able of generating highly attractive returns.

The Tide Has Changed

Investors have demanded more. In 2008 they ‘spoke with their feet’ and the hedge fund industry suffered $782bn of redemptions. The Hedge Funds had to listen. What was requested, according to a report by Scorpio Partnership, was “transparency, simplicity and liquidity”. Likewise, the Hedge Fund Scandals were a wake up call to investors and much more focus is being placed on operational due diligence, to avoid investing in any future hedge fund failures.

Investment Insight: Well-Positioned to Exploit Opportunities

With the risk of future macro shocks clouding the horizon (read: Japan, Middle East, EU Sovereign Debt), the direction of the markets is somewhat hard to predict. Therefore investing with flexible managers able to react to the quickly changing environment and nimble enough to exploit opportunities when they present themselves seems an attractive move. Not all investments are created equal, some are more equal than others.

The Problems of “Absolute Returns”

“How often misused words generate misleading thoughts.”   Herbert Spencer (British social Philosopher, 1820-1903)

When it comes to discussing hedge funds, the quote above rings true. Mis-sold and mis-understood, investors have been left disillusioned. Marketed as being able to generate “absolute returns” in all environments, and tarred allwith the same brush in a “one size fits all” sell, appropriateness was often overlooked. All the catchy phrases and vague promises have mis-managed investor expectation and clients spoke with their feet. As we look to the future, with the next generation of “more highly regulated funds”, we must be wary to not fall foul of over-promising and under-delivering…

Common Misconceptions:

1. “Shorts” as a means of risk-reduction to balance “long” exposure vs. ability of funds to be hurt on both the long and short side together due to e.g. unexpected deal surprises. For example, in late October 2008 hedge funds lost £18bn in two days of trading due to a costly short call. Managers had bet on VW shares falling because of the global economic downturn but once Porsche revealed they had been secretly building their stake to a controlling share, they scrambled to cover their positions.

2. If so-and-so are investing, then sufficient due diligence must have been carried out”. Just take the Madoff ponzi scheme – half of UBP’s 22 fund of funds invested, HSBC provided finance to clients who invested, many successful individuals invested large amounts…. It comes back to the basic tenet – “Never invest in a business you cannot understand “ (Buffett)

3.  If I get nervous, I can always take my money out. Following on from point 2, without investigating a fund – the liquidity of its underlying investments, the commitment of major shareholders etc., many were shocked when fund of funds, in particular, implemented side-pockets and gates to limit the amount a client could redeem.

4.  “Larger funds are always safer” In actual fact it was many of the larger funds that found it hard to meet redemptions – needing to liquidate a larger amount in the market and slower to implement changes in strategy as markets sold off back in 08. Instead it was the smaller, more nimble players that were able to adapt quicker to navigate the markets better, and able to meet redemption requests more easily and avoid having to implement side-pockets or gates.

5. “Paying an extra layer of fees is worth the diversification benefits of a fund of funds investment – although still true in some instances, many fund of funds are merely “best of breed” funds with less emphasis on portfolio construction and therefore less of an uncorrelated nature. In addition, those that paid less attention to the liquidity of their underlying funds were squeezed when these funds gated whilst they were receiving redemption calls.

What can we do with this information?

1. More accurately assess the risk profile of a hedge fund investment, size and position allocations accordingly

2. Ensure a full due diligence process has been carried out

3. Assess the liquidity of the assets the fund is investing in and interview large fund shareholders – a managed account is not always necessary, the emphasis should be on appropriateness – daily liquidity is suitable for a large-cap global equity fund but a more private equity-type fund could suffer from too much focus on managing flows than managing the money itself.

4. Look for the sweet spot that exists at the point when a fund’s running costs are comfortably covered and there are low operational concerns, whilst the manager still has the hunger to perform before becoming complacent and managing more than he is best at handling.

5. Watch the correlation of the fund to other parts of your portfolio and to the managers within the same asset class to ensure sufficient diversification benefits – mitigating some of the volatility for steadier returns.

MANAGE CLIENT EXPECTATIONS