The Scam That Outscams "The Scam"

The Bernie Madoff Ponzi scheme is generally regarded as the biggest financial scam of all time. I don't agree.

Hedge funds, and particularly "fund of funds," make Bernie's despicable conduct look like small potatoes.

The underlying premise of hedge funds -- outsized returns with no increase in risk--is fatally flawed. Numerous studies have demonstrated the vast majority of these funds do not beat the returns investors could obtain for themselves, by investing in a simple S&P 500 index fund.

It was only a matter of time before these funds started to implode. According to a web site that tracks hedge fund failures, 108 funds at 66 firms have gone of business since 2006. Many more are sure to follow.

While the pitch of hedge funds is a scam standing alone, the "fund of funds" embellished the con. These funds charged 1% or more for selecting and monitoring the performance of "the best" managers.

This scam relied on the gullibility of investors who believe "best managers" is not an oxymoron. The data clearly indicates that it is. If you own an actively managed fund, the odds of it beating its benchmark over 1 year is 1 in 3, over 5 years it's 1 in 5, over ten years it's 3 in 100 and over 25 years it's essentially zero!

How anyone can claim to be able to beat these odds and convince so many sophisticated investors they should pay them to do so, is the poster child for a combination of greed and cognitive dissonance.

Enter the track record of Bernie Madoff. Fifteen years with steady returns of 11%. This was something fund of funds could really sell -- and they did. Some funds reaped hundreds of millions of dollars of fees for simply forwarding billions of dollars of assets to Madoff. These investors felt privileged to gain access to him and were happy to pay the fund fee, secure in the knowledge that Madoff was being closely monitored.

You know what happened next.

Here's the real scam: How motivated were these "fund of funds" to carefully monitor Madoff's performance? Did they really want to kill the golden goose? Or is it likely they either knew his returns were too good to be true or engaged in "willful blindness" to his fraud?

It would not have been difficult to detect his misconduct. He used an obscure accounting firm. He had no independent custodian. These are major red flags.

Or, they could simply have read a 2001 story about Madoff written by Erin E. Arvedlund in Barron's.

The article was skeptical of Madoff's track record and noted "[T]hree option strategists for major investment banks told Barron's they couldn't understand how Madoff churns out such numbers using this strategy."

Of course, real monitoring would have included replicating Madoff's results. No one has been able to do so....and with good reason.

The real beneficiaries of the scam are these funds. Their rewards dwarfed those received by Madoff.

They are the ones who engaged in the scam that outscams "The Scam."
