Madoff's Ponzi continued

The story just keeps getting more outrageous. The two senior employees who questioned Madoff and uncovered the fraud happen to be his sons. They then turned him in. Imagine their horror at discovering the almost 50-year old family business was a complete fraud? (That assumes they weren't part of it.)

Madoff had a fund containing some $17 billion in investors' money. According to the Wall St. Journal, this fund promoted regular returns through a strategy of selective short-term trading and going to cash or T-bills when the market was unfavorable. The goals was to deliver roughly 1% per month in returns- a stable return despite the market's ups or downs.  Since December of 1990, this fund "reported" annual returns of 10.5% per year with low volatility and great reliability. As with all classic ponzi schemes, the investment opportunity is a bit too good to be true, but succeeds in luring investors in anyway. Which begs the question why regulators didn't catch this or how the investors themselves, some being very sophisticated, didn't suspect something?

I placed a call to former regulator and highly respected expert in regulatory matters that I know (thanks) and he was able to offer some possibilities of how this may have happened. Recall Madoff had two businesses- an investment advisor (IA) business and a broker dealer (BD) business. The sons ran the BD firm and Madoff ran his IA firm from a separate floor, under great secrecy.  My sources suspect Madoff never told any regulatory authority he had an IA business. If the SEC and FINRA (FINRA is the successor to the NASD and other regulatory bodies) don't know about a business, they can't regulate it.

It turns out that there is an exemption in the statutes which does not require a fund with less than 15 investors to register. George Soros is not registered under these rules.  So, how does one raise billions with less than 15 investors? A fund may be one of the 15 and obviously a fund might have thousands of investors. The SEC tried to close this loophole a few years ago (that was the "SEC registration" for hedge fund hubbub you may remember), but efforts were thwarted. I did say this was outrageous.

Tremont Capital is a fund of hedge funds. Their value proposition is that they evaluate many, many hedge funds and create a fund that combines different managers. Typically, a single hedge fund might have a quarter or half a million minimum investment (or more). To diversify into several hedge funds is beyond reach of most people as is performing due diligence on each one. With a fund of funds, an investor could put in a relatively small amount and be diversified across a dozen or so hedge funds. Using the fund of funds improves an investor's diversification on more modest sums. From their website (emphasis mine): "Effective investment strategies and oversight, thorough manager research, careful due diligence, advanced risk allocation and time-tested portfolio management form the cornerstones of a comprehensive platform".  In providing such an investment, Tremont is responsible for doing due diligence on the mangers/hedge funds it selects. In other words, they missed Madoff's fraud big time.

How could a large, sophisticated investor with an army of lawyers doing due diligence miss this? Investors like Tremont missed the fraud because Madoff probably had no registration and faked the books. Tremont trusted what they saw, apparently not being suspicious of the "too good to be true" results. Now, I am speculating on how this could have happened.  There is no evidence available that suggests the above scenario is actually how it happened. For all we know, Tremont was scammed in an entirely different manner beyond anyone's reasonable ability to get the facts. Tremont may have done everything it could be expected to do in determining legitimacy. Except being suspicious of the returns and strategy itself. The bottom line to all this: if it sounds too good to be true- it is probably best to pass on the "opportunity". Such phenomenal results are always suspect. Overriding your greed instinct with practical expectations is the best defense. Time will shed light of the facts and manner of this case's fraud, but the previous statement always holds true.