The Old Fashioned Way

I see that Paul Eustace, former manager of the hedge fund Philadelphia Alternative Asset Management, has been ordered to return $279 million to clients and pay a $12 million civil penalty (http://news.yahoo.com/s/nm/20080819/bs_nm/hedgefund_fraud_dc;_ylt=Al63G7G60fmYlUYT1QUXBce573QA).



Hedge funds make their money in a lot of different ways, and in fact there is no single strategy they use.  They try to give good returns, more or less uncorrelated to the direction of any individual market, and in exchange they charge hefty upfront fees and get an an even heftier percentage of the profits.  PAAM, on the other hand, made their money the old fashioned way:  they stole it.  They lied about what they were doing, lost money trading, sent out false statements to their clients, and continued to collect their fees.  For years.

What's amazing to me about this case and others like it is that there are basic controls that exist to prevent this sort of thing, and investors have to willfully short circuit them in order to get defrauded.  For example, PAAM traded entirely in commodity futures, so they could easily have been set up so that investors didn't have to rely on them for account statements.  Each investor could have used a broker completely outside PAAM's control - in which the hedge fund had trading rights but no ability to touch the actual funds.  Obviously, investors were convinced by someone not to take this basic step.  For a hedge fund set up to take control of funds, there are other protections in place, but investors are often made to feel like they have to trust the manager.  Yeesh.

And we're not talking about mom and pop candy store investors, either.  We're talking about sophisticated - okay, well, at least rich - investors with millions and millions of $$$ to invest, and they still make the same mistakes that people walking down the street make when they play 3-card monty.  I don't want to blame the victim too much, but c'mon folks - when you get in bed with a hedge fund manager, make sure somebody's wearing a condom, okay?