Why a Madoff-type scandal isn't likely in the fund world.
By David Kathman, CFA, Ph.D. | 01-13-09 | 06:00 AM | Email Article

Investors who were already shellshocked from the market's heavy losses got an additional unpleasant surprise in the final month of 2008: the Bernard Madoff scandal. Madoff ran a $50 billion investment fund with an exclusive reputation, but the whole thing turned out to be a massive Ponzi scheme, in which existing investors' returns came out of the money contributed by new investors. Now all that money is gone, and lots of people who thought their investments were safely earning 10% to 12% a year are left with nothing, wondering how this happened.

David Kathman, CFA, Ph.D., is a senior manager research analyst for Morningstar.

This fiasco has naturally caused a lot of soul-searching, not just among people who lost money to Madoff (some of whom have been writing about their experiences), but also among ordinary investors wondering if they could fall victim to a similar scam. That's a natural reaction, and Morningstar's Sonya Morris and John Rekenthaler have already weighed in on some of the lessons that can be drawn from this scandal. But while it's important to be cautious and do your homework, it's also important not to extrapolate too much from the Madoff scandal, as bad as it is. Ordinary mutual fund investors, in fact, are protected in numerous ways that make a mutual fund version of Madoff very unlikely.

The Importance of Transparency
One of the things that allowed Madoff to get away with his scam for so long was the almost total lack of transparency in his business. Like a lot of hedge fund managers, Madoff refused to provide many details about his strategy, which supposedly used a combination of blue-chip stocks and options to generate remarkably consistent double-digit returns year after year. For years various critics questioned whether this strategy was capable of generating such returns; in 2005, the most persistent such critic, Harry Markopolos, detailed his concerns in a report to the Securities and Exchange Commission called "The World's Largest Hedge Fund is a Fraud." But because hedge funds aren't required to disclose very much, these critics couldn't prove anything, and Madoff was always able to come up with excuses that got him off the hook. Nobody even knew exactly how much money Madoff was running, let alone where he had invested it.

Such a lack of transparency has the potential to lead to lots of other problems in the hedge fund industry, beyond the actual problems caused by Madoff. As John Rekenthaler recently noted, finance professors Dean Foster and Peyton Young have written a paper called "The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics", in which they show how easy it would be, in theory, to use options to "piggyback" and mimic the returns of any fund over time with virtually no effort, but with a small probability each year that the piggybacking fund will lose all its value. Given the general lack of transparency in the hedge fund industry, somebody could theoretically start a hedge fund using this method to beat the market each year and gather lots of assets; such a fund would be indistinguishable from a true market-beating hedge fund, at least until it blew up and lost everything.

Protecting Investors
One reason that hedge funds are so lightly regulated is that, at least in theory, they're marketed to wealthy, sophisticated investors who understand and can handle the risks involved. But as the Madoff case shows, such investors don't always understand what they're getting into and are capable of being fleeced by someone who knows a little psychology. By all accounts, Madoff used the secrecy surrounding his fund to build up an aura of prestige and exclusivity, so that many of his victims felt privileged to be allowed to invest with him and didn't ask too many questions. He also recruited many of his investors from the Jewish community, who trusted him as one of their own.

Brazen deception of this type would not be possible with a mutual fund, or, at the very least, it would be much more difficult to pull off. Mutual funds are required to disclose their portfolio holdings at least once a quarter, and they also have to disclose many other details about their operations, including expenses and the names of their largest shareholders. Each mutual fund is also overseen by a board, whose job it is to look out for shareholders' interests and make sure nothing untoward is going on. Perhaps most importantly, funds have to update their net asset value every day, so that investors know exactly how much a fund is gaining or losing. Of course, mutual funds are still capable of engaging in funny business, as the market-timing and late-trading scandals of five years ago illustrate. But the wrongdoing in those cases was not nearly as blatant as in the Madoff scandal and involved much smaller losses to shareholders--nobody came close to losing their life's savings.

None of this is meant to minimize the importance of the mutual fund scandals, which involved major breaches of trust between numerous fund companies and their shareholders. In the wake of the scandals, we launched our mutual fund  Stewardship Grades, which are designed to measure how shareholder-friendly funds are, including any regulatory issues they've had in the past. These grades are yet another way for mutual fund investors to protect themselves against shady doings, in addition to the disclosure and other protections that are already available for all mutual funds.

Hedge fund managers often argue against too much disclosure, because they say it makes it difficult to execute specialized strategies. That may be, but a high degree of transparency makes it much tougher to perpetrate scams. In general, we're fans of letting potential investors know as much as possible about where they're putting their money, which is why we've previously suggested ways in which mutual fund disclosure could still be improved from current levels.


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David Kathman, CFA, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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