Wednesday, December 17, 2008

Hedge funds and snake oil...

I talked to someone today whose parents lost money with Madoff. The person when commenting on potential strategies his parents might use going forward said they are quite leery of alternative investments. Yet the investment strategy (real or perceived) is not the root issue as I explained to this person.

Madoff's firm was dually registered as both a registered investment adviser (RIA) and a broker/dealer. This means he was allowed to give investment advice on how (and with who) people invest their money, get paid to invest money for those who chose to implement through him, and as a broker get paid a fee for executing the transaction, and as the clearing/market making brokerage firm get paid the spread (difference between bid and ask price) on all trades. Shouldn't this have raised a red flag with people smart enough to know better?

So what is he in trouble for? Only looking at the RIA side he is cited for violation of 206 (1) and 206 (2)--basically fraud. In reality because his company was a brokerage firm it printed its own statements. Had it printed the truth of what was happening with the investments, or had it cleared through another brokerage firm, he would not be in trouble. He could still have lost all that money for people, walked away with his millions in fees, and likely be free from criminal prosecution. So why bother risking this outcome when another option with just as much upside and less downside exists?

--Because it wouldn't have as much upside. He was using word of mouth among influential people and the demonstration of consistent 1% returns per month to get more money for his ponzi scheme. Capital flows to places that are perceived by investors to be most productive. If someone consistently shows excess return without a commensurate increase in risk people invest. If not, they don't. Pretty simple, right?

So the snake oil salesman comes into a small frontier town with his wagon of tonics and potions. He displays a believable demonstration of someone being healed from an illness. And everyone buys. Really what is the risk? Well what if it was laced with a slow-acting lethal poison? But who would do such a thing? Once that frontier town had an objective doctor who could examine the contents of the snake oil to find the true ingredients and declare that it is not medically possible to cure blindness, little capital would be allocated to the snake oil. Because objective advice brought enough question regarding the likely excess upside over the likely downside. So we return back to the Australia regulatory system that regulates financial advice separate from product sales.

If you want to run snake oil salesmen out of town then bring in an objective doctor to give a dissenting opinion, which is all that is necessary. If instead the town outlaws snake oil, that same guy will come back with a miracle lotion.

As a side note, most hedge funds are structured as limited partnerships (Madoff was not). Didn't something happen in the late 70's and early 80's that displayed the consequences of mixing investments in a limited partnership structure that removes transparency and the ability to demand a return of capital quickly? A new color of lipstick on the same old pig...

Charles Ponzi would be proud. After he got out of jail from his first scheme in Boston (defrauding federal judges, celebrities, and Congressmen), went to Florida and started selling swamp land. So not only does he get credit for the "ponzi scheme" he also helped grow the term, "If you believe that, I have some land to sell you..."