Madoff and the Hedge Fund Business

Here is a statistic to make your eyes water. CSFB Tremont, keeper of one of the main hedge fund indices, has removed the track record of the feeder funds that channelled money towards Bernard Madoff‘s reported Ponzi scheme. As a result the performance of the market-neutral strategy in the Tremont index has been adjusted from a gain of 0.85% (as originally reported) to a loss of 40%% for the ten months to October 2008!

The overall return from the hedge fund universe this year, according to the same CSFB Termont index, has been restated from minus 14% to minus 17%, all the direct result of the Madoff scandal. Ironically one of the biggest losers is Tremont itself, which directed some $3bn of its clients’ money into his funds. Two other big feeder funds, Fairfield Greenwich and Kingate Global, constituted a large part of the funds that were the basis for the market-neutral segment of the hedge fund index.

I have argued for several years that most of the arguments hedge funds have used to justify their place in investors’ portfolios are intellectually bogus. There are a few very talented individuals who have produced good results over many years, but the industry has become bloated with mediocrity as it has expanded so rapidly and taken in, directly or indirectly, a new breed of investors whose demand has completely outstripped the industry’s capacity for excess returns.

Shorn of the ability to use leverage, the hedge fund concept has at last been shown up for what it is: a hollow vessel. Several academics have shown that hedge fund indices consistently overstate actual hedge fund performance, and the Madoff debacle will further invalidate the credibility of the statistics. While absolute returns are a fine idea, and consistent absolute returns are an even more splendid notion, they are rarely achievable in practice.

Increased regulation is not the answer. Hedge funds worked okay when they were private unregulated pools of capital and the managers had to answer to a small group of wealthy and self-certified sophisticated investors who were deemed to be able to look after themselves. Making them mass market investments was always asking for trouble. The hedge fund model has too many intrinsic flaws to make hedge funds suitable even for most institutional investors, let alone the general public.

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