Madoff's kiss of death for hedge funds

The $50bn Ponzi scheme allegedly run by Bernard Madoff on the 17th floor of New York's Lipstick Building is a disaster for the hedge fund sector. Mathieu Robbins reports

The Madoff situation is, at a time of mass redemptions and dwindling returns, what hedge funds needed least. A spectacular scandal causing huge losses that undermines trust in the industry. The financier's apparent scam, which may have cost investors $50bn, comes as the industry tries to rebuild its tarnished image with cash-strapped and often disillusioned in-vestors who, along with lenders, are withdrawing their money. This redem-ption craze – accompanied by collapsing portfolio values – has already brought the industry to its knees.

So is the Madoff bust the final nail in the hedge fund industry's coffin? Not really, but hedge funds will change.

After starting in the 1980s, as one senior City banker put it, as "shady guys in limos with darkened windows", hedge funds built respectability. Now they have entered the mainstream. As the list of casualties from Madoff shows, their investors range from individuals to pension funds, charities and high street banks. One reason for this spectacular gain in standing is that during the bull market ending last year investors became enamoured with high yields.

Hedge funds pledged absolute returns irrespective of markets and investors were willing to ignore the intuitively higher risk associated with such returns. Coming after a recent slew of hedge fund woes, the Madoff case goes further towards ending that illusion. Part of the problem is quite how respectable Bernard Madoff, in business since 1960 and immensely well-connected, was. It was this standing that allowed him to attract money without needing to provide transparency on investments. As a result, investors will probably feel spooked and redeem more hedge fund money to look for safer investments.

"This will lead to more rash reactions [from banks and investors] and we will probably see as a result of this more [hedge fund] liquidations," said Peter Hahn, a fellow at London's Cass Business School. "This is another event that will add one more step on the caution ladder."

The scandal also raises questions around regulation. While hedge funds are, by definition, less regulated than other vehicles, they still need licences to operate. The US Securities and Exchange Commission granted Mr Madoff approval to conduct his business. The SEC will doubtless now need to answer to US legislators.

"The new financial system we [will] come up with after all this is probably one based on a lot more structured, intrusive and formal structures that mean a lot more regulation," Mr Hahn said.

Some argue that the problem lies with the US model of regulation. The UK's FSA uses principles-based regulation. This, say its advocates, means it evaluates the biggest risks for any particular asset class and more effectively screens businesses applying to operate.

Andrew Shrimpton, a regulatory compliance executive at Kinetic, which provides risk-advisory services to fund managers, said: "It shows how if you have a tick-box approach you miss the elephant in the room.

"The FSA actually have a much better track record at preventing fraud," added Mr Shrimpton, previously the head of Alternative Investments Supervision at the FSA.

Also facing tricky questions are funds-of-funds, which take money from outside investors and place it in an array of hedge funds. They promise to carry out due diligence, so those that got caught out by Madoff, like Man Group's institutional fund of funds business RMF, will doubtless be embarrassed to face their investors.

Despite the issues raised about the industry by their recent predicament, few expect hedge funds to disappear. After all, they have survived previous setbacks such as the 1998 LTCM crisis. And US-based Hedge Fund Research statistics show that while fund closures rose in the first half, there remained a higher number of fund launches.

So will these new funds be different? The short answer is: almost certainly, yes.

One of hedge funds' biggest lures for investors has so far been ease of redemption, and that may need to change. In contrast to private equity, which forces investors to adhere to a lock-in of their investment for the life of a fund, many hedge funds hold contributors in for only a month at a time.

The problem this creates is not just redemptions per se. It is also that redemptions are often out of kilter with investments. A fund taking a three-month bet on a stock, for example, does not want to be forced to sell after one month to return cash to investors.

One way of accommodating all investors is to split the fund, where one part invests in liquid assets and provides investors access to quick redemptions, whereas the other has a longer lock-in period and takes accordingly longer-term bets.

Another intuitive lesson is not to put all your eggs in one basket. Single-strategy hedge funds, those that have focused on a single trick such as M&A-related arbitrage, may have seen their day. As the returns on any single strategy can vary, the need for safety means hedge funds need to broaden their strategies, analysts say.

Funds will also want to revisit the prime broker model of how they interact with banks. Hedge funds have traditionally set up account facilities with banks' prime brokers, which service hedge funds with facilities such as lending shares. But in some instances, banks used the cash for proprietary trading. And in Lehman's case, when the bank went bust, billions of pounds of hedge fund money got locked up.

One solution would be to set up a dedicated account that cannot be traded, from which cash is only released for specific trades ordered by funds. Because banks would not be able to use the money to trade for a profit, the loss of revenue may feed through to fees, making custody a little more costly but a lot less risky.

So while they are facing a difficult time, like any Darwinian case study, hedge funds will survive by evolving.

Boom to bust: Feeling the pain

This has been a truly awful year for hedge funds. Like most industries that overexpand, it hurts when the boom turns to bust. Many have had to call it a day. It started with fixed-income trading. The first high-profile hedge fund to collapse was Carlyle Capital in March. It invested in mortgage-backed securities.

As the credit crunch spread, so did contagion. The US-based industry specialist Hedge Fund Research estimates 350 hedge funds closed in the first half of the year.

The collapse in stock markets is one factor but other events made the impact worse. Lehman's bankruptcy in September, for example, left many fund assets tied up in the messy European administration process and Porsche's creeping control of Volkswagen through options purchases led to a spike in VW's share price in October and funds that were shorting those shares losing billions of euros.

London-based RAB Capital is closing several of its funds; Centaurus, another London boutique, closed its $1.2bn (£786m) Alpha fund and launched new funds this month after investors rejected a plan to restructure the portfolio; and the iconic Citadel has closed its Asian business. This is just the start: Most industry-watchers agree that many more funds are set to go bust.