Is Madoff the tip of the iceberg?

Date: Tuesday, November 10, 2009
Author: Mike Mangan, 2MG Asset Management

It’s pretty easy to pass an exam if you’ve seen the exam paper beforehand. And it's even easier to become a billionaire if you’ve been tipped off about the next corporate announcement. Judging by recent developments that seems to have been the modus operandi of many hedge funds. But something really, really big seems to be stirring in 'Hedge Fund Land'. In the last several weeks a number of international hedge funds have been shuttered, and their principals arrested. First Galleon in the US, then K1 in Germany, and then back to the US where a further 14 people including one known as the 'Octopussy' were nabbed last week. This all follows 'Sir' Allen Stanford’s $US8 billion ponzi uncovered in March. Could it be that (shock, horror, gasp), Bernie Madoff’s $US69 billion hedge fund fraud was just the tip of a very large, and very ugly iceberg?

It’s not just the numbers involved that is interesting. It’s the methods employed by US authorities to catch these white collar thieves. Wiretaps, hidden recording devices and other methods normally reserved for the 'mob' have been deployed. Charges mentioned include 'wire fraud' and racketeering. If proved they carry prison sentences of years if not decades in a federal penitentiary. Faced with this, many witnesses are rolling over and naming names. So like a virus, the net expands, engulfing more and more former 'masters of the universe'.

For those with a history bent, this is how Ivan Boesky and Michael Milken were given up in the eighties. However, there are two significant differences this time. First, the authorities are using investigative techniques as well as legislation initially framed to catch the mafia.

Second, (and to misquote Peter Finch from the flick Network), society is “mad as hell and they are not going to take it anymore”. Every arrest is met with rapturous applause. The GFC caused massive wealth and job losses. 'Society' wants vengeance. When Nero needed a scapegoat for the fire of Rome, he blamed the Christians. Inside traders at hedge funds are just as guilty of causing the GFC. But that won’t stop 21st century society blaming them. And after Madoff received 150 years it’s clear neither judges (nor politicians) will have sympathy for any billionaire or millionaire caught gaming the system.

If you ask me, something has been rotten about the whole hedge fund industry for a long time. It is well known that during the GFC many 'hedgies' were intimately aware of the details of the margin loans and trading activity of large corporate shareholders and senior executives. In Australia, Challenger and Fairfax come to mind. How did they get that info – not out of studying the annual report and other company releases. Market rumour at the time suggested 'hedgies' were paying insiders within the margin lending companies to access this info. If true, it was outrageous. And in at least one instance (Fairfax), the company was forced into making a massive and very dilutive capital raising. As far as I’m aware, the Australian corporate 'watch dog' (or is that puppy dog?) never investigated. It should have. Probably never even crossed their mind.

Like many 'long only' funds, the fund I work for aims to achieve a modest return of between 3 per cent and 5 per cent per annum above benchmark. If we can do that, our clients should grow rich, but slowly. But many hedgies are delivering those sorts of returns in a week. Indeed one common denominator among all the fraudsters caught so far is their outsize returns. In 15 years Madoff hardly had a negative month using his proprietary 'split strike conversion' methodology. No doubt when investors heard about the 'split strike', their eyes glazed over and their minds wandered off to all the $$$ bills they would soon own. Outsize returns would appear to be a good filter for any aspiring corporate cop.

Another good filter might be massive portfolio turnover. Apparently Galleon was turning over 70 per cent of its portfolio each quarter. While that would make Galleon a broker favourite, it’s about four times the turnover in our funds. It’s another clue these guys are probably acting on insider tips and not fundamental analysis.

'Hedgies' demand absolutely secrecy because (they said), they feared their proprietary methods would be copied by competitors. Madoff was so secretive he swore his clients not to even tell anyone he was their hedge fund manager. More likely, many 'hedgies' have been engaged in insider trading and other fraudulent activity on a massive scale. Their real fear was getting caught. So a third filter might be the level of hedge fund secrecy. The greater the secrecy, the more likely the 'hedgie' fits the FBI description of former Galleon billionaire Raj Rajaratnam, “not a master of the universe, just a master of the rolodex”.

Of course not all 'hedgies' have gone to the dark side. In 2007 Paulson & Co made $US15 billion from betting against the US housing bubble. He did that not through insider trading but through the identification of a huge bubble and the correct analysis of how to bet against it. Well done.

How about this for a forecast? And it's not from an insider. It’s merely what we fundamental investors call a logical deduction. If insiders can’t use email, mobiles or land lines to download their highly valuable payload, if even a favourite nosh pit can be wired, hedge fund returns are likely to gravitate back towards the benchmark? Because if these 'hedgies' don’t wake up and smell the breeze, striped pyjamas and soap bars await.
 
Mike Mangan is a portfolio manager at 2MG Asset Management