What's that behind the hedge?
16 Dec 08
Bernie Madoff’s $50 billion hedge fund fraud starkly shows up how unregulated and risky this sector still remains. Why should the ordinary punter worry? Because we are investing in hedge funds by proxy, whether we know it or not.
What the financial world needed this week was a period of calm, and some indication that, even if the coming twelve months may be tough we will be spared the series of shocks that rocked 2008. What it got, however, was the revelation that Wall Street hedge fund ace Bernie Madoff had confessed to what may be the biggest fraud in US history.
Bernard L Madoff Investment Securities appeared to be a cannily invested hedge fund that somehow managed to buck the market, producing double-digit growth for its investors while many rivals saw their assets plummeting in value.
In fact, Madoff’s operation was, as he confessed himself, “basically, just a giant Ponzi scheme.”
Every accountant should be familiar with the structure of a “Ponzi” fraud – where market-beating returns are achieved only through using newly invested money to pay out existing investors – and indeed, the structure of a Ponzi fraud is quite simple. It’s the concealment that is complex and difficult. The other thing about the Ponzi model is that it is doomed to failure; with only six billion humans on the planet, you will eventually run out of new investors to con.
Apart from the scale of the alleged Madoff fraud, one of the other things that stands out is that the victims were not all just wealthy, gullible individuals. Institutions such as the Royal Bank of Scotland, and high-profile market figures such as “superwoman” Nicola Horlick, also appear to have lost money in amounts up to the hundreds of millions.
The affair shows up just how unregulated hedge funds are even now. The argument from the “hedgies” always used to be that hedge funds are aimed at the sophisticated investor, and are risky at the best of times, so don’t need to kid of regulation that applies to investments aimed at the “ordinary” punter. The fact that many millions of ordinary punters’ money – whether they knew it or not - was invested in Madoff’s collapsed financial empire, by banks and other investment houses, should be enough to make the case for increased transparency and better regulation.