Madoff's kiss of death for hedge funds

The $50bn Ponzi scheme allegedly run by Bernard Madoff on the 17th floor of New York's Lipstick Building is a disaster for the hedge fund sector. Mathieu Robbins reports

The Madoff situation is, at a time of mass redemptions and dwindling returns, what hedge funds needed least. A spectacular scandal causing huge losses that undermines trust in the industry. The financier's apparent scam, which may have cost investors $50bn, comes as the industry tries to rebuild its tarnished image with cash-strapped and often disillusioned in-vestors who, along with lenders, are withdrawing their money. This redem-ption craze – accompanied by collapsing portfolio values – has already brought the industry to its knees.

So is the Madoff bust the final nail in the hedge fund industry's coffin? Not really, but hedge funds will change.

After starting in the 1980s, as one senior City banker put it, as "shady guys in limos with darkened windows", hedge funds built respectability. Now they have entered the mainstream. As the list of casualties from Madoff shows, their investors range from individuals to pension funds, charities and high street banks. One reason for this spectacular gain in standing is that during the bull market ending last year investors became enamoured with high yields.

Hedge funds pledged absolute returns irrespective of markets and investors were willing to ignore the intuitively higher risk associated with such returns. Coming after a recent slew of hedge fund woes, the Madoff case goes further towards ending that illusion. Part of the problem is quite how respectable Bernard Madoff, in business since 1960 and immensely well-connected, was. It was this standing that allowed him to attract money without needing to provide transparency on investments. As a result, investors will probably feel spooked and redeem more hedge fund money to look for safer investments.

"This will lead to more rash reactions [from banks and investors] and we will probably see as a result of this more [hedge fund] liquidations," said Peter Hahn, a fellow at London's Cass Business School. "This is another event that will add one more step on the caution ladder."

The scandal also raises questions around regulation. While hedge funds are, by definition, less regulated than other vehicles, they still need licences to operate. The US Securities and Exchange Commission granted Mr Madoff approval to conduct his business. The SEC will doubtless now need to answer to US legislators.

"The new financial system we [will] come up with after all this is probably one based on a lot more structured, intrusive and formal structures that mean a lot more regulation," Mr Hahn said.

Some argue that the problem lies with the US model of regulation. The UK's FSA uses principles-based regulation. This, say its advocates, means it evaluates the biggest risks for any particular asset class and more effectively screens businesses applying to operate.

Andrew Shrimpton, a regulatory compliance executive at Kinetic, which provides risk-advisory services to fund managers, said: "It shows how if you have a tick-box approach you miss the elephant in the room.

"The FSA actually have a much better track record at preventing fraud," added Mr Shrimpton, previously the head of Alternative Investments Supervision at the FSA.

Also facing tricky questions are funds-of-funds, which take money from outside investors and place it in an array of hedge funds. They promise to carry out due diligence, so those that got caught out by Madoff, like Man Group's institutional fund of funds business RMF, will doubtless be embarrassed to face their investors.

Despite the issues raised about the industry by their recent predicament, few expect hedge funds to disappear. After all, they have survived previous setbacks such as the 1998 LTCM crisis. And US-based Hedge Fund Research statistics show that while fund closures rose in the first half, there remained a higher number of fund launches.

So will these new funds be different? The short answer is: almost certainly, yes.

One of hedge funds' biggest lures for investors has so far been ease of redemption, and that may need to change. In contrast to private equity, which forces investors to adhere to a lock-in of their investment for the life of a fund, many hedge funds hold contributors in for only a month at a time.

The problem this creates is not just redemptions per se. It is also that redemptions are often out of kilter with investments. A fund taking a three-month bet on a stock, for example, does not want to be forced to sell after one month to return cash to investors.

One way of accommodating all investors is to split the fund, where one part invests in liquid assets and provides investors access to quick redemptions, whereas the other has a longer lock-in period and takes accordingly longer-term bets.

Another intuitive lesson is not to put all your eggs in one basket. Single-strategy hedge funds, those that have focused on a single trick such as M&A-related arbitrage, may have seen their day. As the returns on any single strategy can vary, the need for safety means hedge funds need to broaden their strategies, analysts say.

Funds will also want to revisit the prime broker model of how they interact with banks. Hedge funds have traditionally set up account facilities with banks' prime brokers, which service hedge funds with facilities such as lending shares. But in some instances, banks used the cash for proprietary trading. And in Lehman's case, when the bank went bust, billions of pounds of hedge fund money got locked up.

One solution would be to set up a dedicated account that cannot be traded, from which cash is only released for specific trades ordered by funds. Because banks would not be able to use the money to trade for a profit, the loss of revenue may feed through to fees, making custody a little more costly but a lot less risky.

So while they are facing a difficult time, like any Darwinian case study, hedge funds will survive by evolving.

Boom to bust: Feeling the pain

This has been a truly awful year for hedge funds. Like most industries that overexpand, it hurts when the boom turns to bust. Many have had to call it a day. It started with fixed-income trading. The first high-profile hedge fund to collapse was Carlyle Capital in March. It invested in mortgage-backed securities.

As the credit crunch spread, so did contagion. The US-based industry specialist Hedge Fund Research estimates 350 hedge funds closed in the first half of the year.

The collapse in stock markets is one factor but other events made the impact worse. Lehman's bankruptcy in September, for example, left many fund assets tied up in the messy European administration process and Porsche's creeping control of Volkswagen through options purchases led to a spike in VW's share price in October and funds that were shorting those shares losing billions of euros.

London-based RAB Capital is closing several of its funds; Centaurus, another London boutique, closed its $1.2bn (£786m) Alpha fund and launched new funds this month after investors rejected a plan to restructure the portfolio; and the iconic Citadel has closed its Asian business. This is just the start: Most industry-watchers agree that many more funds are set to go bust.

Arts and Entertainment
Flora Spencer-Longhurst as Lavinia, William Houston as Titus Andronicus and Dyfan Dwyfor as Lucius
theatreEXCLUSIVE The Shakespeare play that proved too much for more than 100 people
News
A 1930 image of the Karl Albrecht Spiritousen and Lebensmittel shop, Essen. The shop was opened by Karl and Theo Albrecht’s mother; the brothers later founded Aldi
people
News
exclusivePunk icon Viv Albertine on Sid Vicious, complacent white men, and why free love led to rape
Arts and Entertainment
booksThe best children's books for this summer
PROMOTED VIDEO
Sport
Colombia's James Rodriguez celebrates one of his goals during the FIFA World Cup 2014 round of 16 match between Colombia and Uruguay at the Estadio do Maracana in Rio de Janeiro, Brazil
sportColombian World Cup star completes £63m move to Spain
News
news
News
i100
News
people
Sport
Antoine Griezmann has started two of France’s four games so far
sport
Life and Style
techYahoo Japan launches service to delete your files and email your relatives when you die
Life and Style
Child's play: letting young people roam outdoors directly contradicts the current climate
lifeHow much independence should children have?
News
ebookA unique anthology of reporting and analysis of a crucial period of history
Arts and Entertainment
Tycoons' text: Warren Buffett and Bill Gates both cite John Brookes' 'Business Adventures' as their favourite book
booksFind out why America's richest men are reading John Brookes
News
i100
Arts and Entertainment
<p><strong>2008</strong></p>
<p>Troubled actor Robert Downey Jr cements his comeback from drug problems by bagging the lead role in Iron Man. Two further films follow</p>
filmRobert Downey Jr named Hollywood's highest paid actor for second year running
Life and Style
Dale Bolinger arranged to meet the girl via a fetish website
life
Property
Sign here, please: Magna Carta Island
propertyYours for a cool £4m
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Programme Director - Conduct Risk - London

£850 - £950 per day: Orgtel: Programme Director - Conduct Risk - Banking - £85...

Business Analyst (Agile, SDLC, software)

£45000 - £50000 Per Annum + excellent benefits: Clearwater People Solutions Lt...

Finance Manager - Bank - Leeds - £300/day

£250 - £300 per day + competitive: Orgtel: Finance Manager - Accountant - Bank...

Compliance Officer - CF10, CF11, Compliance Oversight, AML, FX

£100000 - £120000 per annum + BONUS + BENEFITS: Harrington Starr: A leading fi...

Day In a Page

Some are reformed drug addicts. Some are single mums. All are on benefits. But now these so-called 'scroungers’ are fighting back

The 'scroungers’ fight back

The welfare claimants battling to alter stereotypes
Amazing video shows Nasa 'flame extinguishment experiment' in action

Fireballs in space

Amazing video shows Nasa's 'flame extinguishment experiment' in action
A Bible for billionaires

A Bible for billionaires

Find out why America's richest men are reading John Brookes
Paranoid parenting is on the rise - and our children are suffering because of it

Paranoid parenting is on the rise

And our children are suffering because of it
For sale: Island where the Magna Carta was sealed

Magna Carta Island goes on sale

Yours for a cool £4m
Phone hacking scandal special report: The slide into crime at the 'News of the World'

The hacker's tale: the slide into crime at the 'News of the World'

Glenn Mulcaire was jailed for six months for intercepting phone messages. James Hanning tells his story in a new book. This is an extract
We flinch, but there are degrees of paedophilia

We flinch, but there are degrees of paedophilia

Child abusers are not all the same, yet the idea of treating them differently in relation to the severity of their crimes has somehow become controversial
The truth about conspiracy theories is that some require considering

The truth about conspiracy theories is that some require considering

For instance, did Isis kill the Israeli teenagers to trigger a war, asks Patrick Cockburn
Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

Alistair Carmichael: 'The UK as a whole is greater than the sum of its parts'

Meet the man who doesn't want to go down in history as the country's last Scottish Secretary
Legoland Windsor's master model-makers reveal the tricks of their trade (including how to stop the kids wrecking your Eiffel Tower)

Meet the people who play with Lego for a living

They are the master builders: Lego's crack team of model-makers, who have just glued down the last of 650,000 bricks as they recreate Paris in Windsor. Susie Mesure goes behind the scenes
The 20 best days out for the summer holidays: From Spitfires to summer ferry sailings

20 best days out for the summer holidays

From summer ferry sailings in Tyne and Wear and adventure days at Bear Grylls Survival Academy to Spitfires at the Imperial War Museum Duxford and bog-snorkelling at the World Alternative Games...
Open-air theatres: If all the world is a stage, then everyone gets in on the act

All the wood’s a stage

Open-air productions are the cue for better box-office receipts, new audiences, more interesting artistic challenges – and a picnic
Rand Paul is a Republican with an eye on the world

Rupert Cornwell: A Republican with an eye on the world

Rand Paul is laying out his presidential stall by taking on his party's disastrous record on foreign policy
Self-preservation society: Pickles are moving from the side of your plate to become the star dish

Self-preservation society

Pickles are moving from the side of your plate to become the star dish
Generation gap opens a career sinkhole

Britons live ever longer, but still society persists in glorifying youth

We are living longer but considered 'past it' younger, the reshuffle suggests. There may be trouble ahead, says DJ Taylor