The end of fund of funds

The $50 billion fraud by Bernard Madoff probably spells the end of the fund-of-funds business. While Madoff wasn't operating a hedge fund, he was using some techniques that hedge fund traders would apply — or at least he said he was.

Friends and acquaintances took him at his word. But so too did a number of fund-of-hedge funds providers. Whatever else their operational omissions, a critical fault was the failure to insist that client assets be held in a separately managed account.

Of course, the potential for fraud should easily have been spotted, says one observer.

"Madoff was probably the easiest [fraud] around the world to avoid because there were so many things wrong with it," says Jack Schwager. "It wouldn't even get to first base in the due diligence process. If nothing else, the first deal stopper is that the manager is the same as the organization that's generating the brokerage statements. That is the biggest violation you can possibly have." Schwager is a principal and senior portfolio manager with Fortune Asset Management, whose Canadian partner is Highview Financial Group.

Funds of funds provide a model, but not the structure, for conservative investing, he notes. While hedge fund databases are notorious for their biases, including self-selection, whereby successful managers report and unsuccessful ones don't, the same is not true for databases that look at funds of funds.

"Hedge fund indexes, because there's so much self-selection involved, are complete garbage," he warns. "However, what is neat is that there really is a way to see what's going on. And that is by looking at what the fund-of-funds indexes do. Because of all these biases, a fund blowing up or being a fraud — let's say we were stupid enough, I wouldn't say unlucky enough, to give money to Madoff — I would love to say let's take him out of the portfolio and not include him. But I have no choice. My results reflect that investment and if that investment is going to zero I can't hide it."

The databases indicate that fund of funds are safer than traditional long-only investing, he says. "So you have an investment area — I would hesitate to call it an asset class because it's so varied — which has returned better than the S&P 500. Either it provides the equivalent return at much less risk or much better return at the same risk."

Still, clients would have been better served had they been invested in separately managed accounts. The structure of funds of funds is simply too opaque, compared to a managed account.

"That is probably going to be more of the future direction," he says. "There's one catastrophe after another that just reinforces the need for transparency — and the advantage of having liquidity."

While frauds are easy to spot, Schwager says, it's the blowups — like Amaranth — that are equally worrisome in a fund-of-funds structure.

"I consider blowups to be much more of a problem than frauds," he says. "Frauds you can usually spot ahead of time. Blowups are much more difficult because everything looks fine, but you don't know what they're doing. You don't know if they're starting to take much more risk on; you can't see it. It only takes one month and by the time you get the statement, it's too late."

That's where the managed account comes in.

"There's nothing that can beat having the account in investor ownership and having someone every day who's looking at the position and pricing the portfolio. That way it's pretty certain I can't take on undue risk or violate the trading mandate or do something different from what I said I would do without someone noticing."

While Schwager is a booster of alternative strategies in general, he sets limits on what works. Liquidity is just as important as transparency.

"You want to have an independent price in the portfolio, if you want to feel comfortable that what you see is real. There's lot's of instances where things get marked on the assumption that they're not going to get sold, but if they have to be sold, the mark would be very different."

That's especially important in the current environment, where all correlations seem to be heading to one. "It's not mysterious why it happens. It happens for a very specific reason. It's liquidity. Of course managers have different portfolios, but as an industry, hedge fund managers tend to be long the same kind of stock," he explains. "There's not a large part of the hedge fund industry that tries to find stocks that are highly inflated. The amount of those longs in the hedge fund community is very small. The amount of the shorts may be very significant."

A shock tends to affect everyone, he adds.

"One manager has to get out. Another manager is sitting there, his portfolio seems perfectly sound, balanced between longs and shorts, but his quality longs are doing much worse than his garbage shorts and the reason is people are under liquidation pressure to cover their longs and cover their shorts."

The solution is to limit the instruments the manager trades, he points out.

"There's only one way to avoid it and that's to hold things that are so liquid that liquidation pressure is irrelevant. That would be markets like futures, currencies or large cap stocks that trade with some frequency."

It's not the only way to invest, he says. "You have to decide as an advisor: what do you want? Are you interested in short-term alpha and do you want the liquidity? Then you have to focus on strategies that have liquidity. You're not going to buy things for pennies on the dollar."

(01/23/09)