Bernie Madoff scandal spells the end of funds of hedge funds

Not one of the hedge funds of funds or banks that steered investors to Bernie Madoff’s funds has admitted their idiocy in failing to spot huge red flags. They have all tried to blame the SEC and other regulators. While the regulators failed spectacularly, even a successful effort on the part of regulators could not have stopped Madoff before he had harmed many investors. That was the case with Enron, with Bre-X, with US Windfarming, and with every penny-ante Ponzi scheme. A regulatory authority cannot act until a crime has been committed, and because of the need to prove a crime, there is little chance of stopping frauds when they begin.

On the other hand, investors (particularly funds of funds and banks, which have the skills and money to conduct thorough due diligence) only need to suspect that something is not right to choose not to invest and avoid losing money to a fraud. That is why I chose not to invest with US Windfarming (even though at the time I knew nothing about investing). If the large investors had done even a modicum of due diligence they would have seen the red flags such as the size of Madoff’s auditor and his insanely consistent returns.

Some commentators have argued that the Madoff scandal will harm hedge funds. That is likely, but the effect will be much greater on funds of funds. If an annual fee of 1.5% of assets under management does not mean that a FOF will perform basic due diligence, then FOFs are doomed. Even in the best of circumstances there is little point to FOFs. I predict that the number of funds of funds and their assets under management will shrink by over 80% in the next couple years. The world will be a better place as a result.

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