Bernard Madoff $50 Billion Ponzi Scheme

[scion]

Funds of Funds' Madoff Problem

By SIMON NIXON
DECEMBER 15, 2008, 4:14 P.M. ET
http://online.wsj.com/article/SB122937379348807659.html?mod=djemheard

The fund of hedge funds industry needed the Madoff scandal like a hole in the head.

Already reeling from the financial crisis, assets under management fell from $826 billion at the end of June to $685 billion by the end of October, according to Hedge Fund Research. The fact that so many leading industry names were duped by Madoff, including Man Group's RMF and Banco Santander's Optimal, will be another major blow to trust -- with consequences felt across the hedge fund industry.

That's because funds of funds (FOFs) are responsible for nearly half of all investment in hedge funds. FOFs sold themselves to investors -- both institutional and retail -- on the basis they offered three important advantages: diversification, access to sought after managers and due diligence. The financial crisis had already done for the first two; Madoff may do for the third.

The case for FOFs as a means of diversification has been undermined by poor results. In the year to the end of October, the average FOF was down 19% -- worse than the average single manager hedge fund which was down 17.7%. Diversification has proved little use in a crisis where asset classes have tended to correlate. Losses have often been amplified both by the effects of leverage plus extra layers of fees. Investors must pay steep FOF charges as well as those on underlying funds.

Nor can FOFs expect to market themselves on the basis of privileged access to sought-after strategies. Before the market crash, many top managers had closed their funds to new investors. That's hardly a problem now. With most of the industry grappling with massive redemptions, new investors would be welcomed with open arms.

But what makes the Madoff scandal so toxic is that it strikes at the most important claim of all: that FOFs vigorously checked out the managers to whom they committed capital. True, Madoff was not a typical hedge fund, many leading FOFs spotted enough warning signs to give him a wide berth and many of Madoff's victims seem to have been exposed via private banks. Those will face reputational risk and potential costs from legal claims or making their clients whole.

But in an industry that depends on trust and confidence, the fact that so many respected names fell short is likely to lead to yet more redemptions across the sector. And that's not just a problem for FOFs. It's also a problem for the wider hedge fund industry.

Few investors -- either institutional or retail -- have the time, expertise or scale to make do their own due diligence on individual hedge fund managers. The risk is that if they lose faith in FOFs, they will turn their back on the hedge fund industry altogether.

Write to Simon Nixon at [e-mail]

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