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End of the Hedge Fund?

By Sebastian Mallaby
Thursday, December 18, 2008

For sheer toe-curling embarrassment, it may be a while before Wall Street does better than the Bernard Madoff scandal. Here was a rogue who practically telegraphed his unreliability by hiring a tiny, no-name audit firm, by reporting monthly investment results that never fluctuated and by claiming a trading strategy that could not possibly have been implemented given the billions of dollars he managed. And yet, despite these warnings, the rich, the famous and the supposedly sophisticated entrusted their money to Madoff, who defrauded them with the most laughably crude of methods -- an old-fashioned Ponzi scam.

The question this prompts is not really about regulation, though some argue otherwise. Even if you define Madoff's investment outfit as a hedge fund, which for various reasons is debatable, there's nothing in this saga that supports clamping down on the industry.

Those who favor regulation of hedge funds start by insisting that they must register with the Securities and Exchange Commission. Well, Madoff had registered with the SEC voluntarily, and a fat lot of good it did. Those who support regulation also say that hedge funds should disclose more of what they do. Well, Madoff did make some disclosures; it's just that they weren't true. As SEC Chairman Chris Cox has all but admitted, the scandal doesn't show that his agency lacked the power to regulate; it shows that it failed to exercise it. Responding to this scandal with more regulation would be like thrusting more pills on a patient who refuses medication.

The real question posed by this episode concerns the market's response. Madoff illustrates a problem with investment outfits that claim to have some special sauce that is too valuable to discuss. People who entrusted their money to Madoff thought he had a clever options trading strategy; they were wrong. Worse, people who entrusted their money to respected banks and investment advisers had no idea that their savings were being passed out the back door to Madoff. On Monday, I happened to be visiting one of the most famous traders in Manhattan. He had invested with a hedge fund that had in turn invested with Madoff, hot-potato style.

The good news is that Madoff's fraud was so brazen that any future imitators may be spotted. A newly chastened wealth management industry will be warier of people who hire bucket-shop auditors; the "fund of funds" industry, which gets paid to do due diligence on hedge funds, will feel appropriate pressure to redouble its efforts. Even though hedge fund managers may legitimately refuse to disclose their trading strategies, there are some things they can be open about. Do they trade through a respected external broker? (Madoff apparently didn't.) If their returns clock in at 1 percent per month with eerie consistency, can they explain why? (Madoff could not have.)

But the bad news is that less-brazen fraudsters may be impossible to detect. As the economists Dean Foster and H. Peyton Young have elegantly demonstrated, hedge funds can fake brilliance by taking a small risk of implosion, and since implosion would hurt them less than their customers, some will rationally decide that faking is the way to go. A fund can take in $100, stick it in the S&P 500 index, then earn, say, $5 by selling options to people who want to insure themselves against a market collapse. If the collapse occurs, the hedge fund's value will go to zero. But, over a five- or even 10-year time frame, the odds are good that a collapse won't happen. So each year the fund manager will beat the S&P 500 index by 5 percentage points. He will be hailed as a genius.

Foster and Young suggest that this Achilles' heel could eventually kill hedge funds. Because it is possible to commit undetected fraud, the industry will attract fraudsters; eventually, investors will realize that they can't tell the good guys from the bad and yank their money out. If this is going to happen, the Madoff scandal could be the catalyst, especially because it has hit at a time when hedge funds are in trouble for other reasons. Hedge fund strategies depend on borrowing, or "leverage," which is hard to come by now. They often depend on "shorting" stocks -- that is, betting that they'll fall in value -- but regulators have restricted that practice. Even before the Madoff scandal, there were estimates that hedge fund assets might shrink from just under $2 trillion a few months ago to perhaps $1.4 trillion.

But it would be wrong to count the hedge funds out. Perhaps half of all funds use strategies about which there is no great secret, so disclosure is possible: The Foster-Young argument does not cut so sharply here. The other half can find ways to signal their honesty without disclosing their tactics: The most obvious is for managers to keep a serious amount of their own money in their funds. Good hedge funds really do know how to make money out of market inefficiencies. After the past 18 months of mayhem, it should be painfully obvious that there is plenty of inefficiency around.

smallaby@cfr.org

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