Can Hedge Funds Be Fraudulent?

I'll be on NPR's Planet Money podcast today, trying my best to explain what a hedge fund is. As John Gapper says, it's crucial to understand that Bernie Madoff did not have a hedge fund, and that hedge funds tend to have prime brokers, which act as an extra pair of eyes and help to prevent outright fraud of the Madoff variety.

On the other hand, there's no shortage of hedge funds which invested in Madoff's fund. Fairfield Sentry was one of them, and its investors are unlikely to be particularly mollified by the fact that Fairfield Sentry was not itself fraudulent: it sent their money off to Bernie Madoff just it said it would.

In fact, the involvement of Fairfield Sentry as a middleman almost certainly made things worse for investors. Not only did they need to pay Fairfield Sentry's fees; they might also have felt reassured by the fact that Fairfield had independent auditors and other common indicia of trustworthiness.

Similarly, in England, people who neither knew nor trusted Bernie Madoff -- people, indeed, who had never heard of the man -- were happy handing over their money to Nicola Horlick's Bramdean. They trusted her, and Bernie managed to piggyback on that trust.

Which goes to show that people who invest in hedge funds should always ask questions about where and how that hedge fund is investing their money. There's not much difference between investing in a black-box fund like Madoff's, on the one hand, and investing in a transparent fund like Fairfield Sentry, on the other, if that entirely transparent fund is only transparent until it reaches Madoff's doors.

Of course, it's not quite as simple as all that: Madoff would construct elaborate and fictional trading statements detailing, ex post, how his returns were achieved. There was an illusion of transparency; he didn't simply tell his investors that he had a black box and they could know no more.

But it's worth tweaking Gapper's point just a little bit: yes, if you're investing your money with a hedge fund which does its own investing, you can have quite a lot of faith it isn't an outright fraud. (Although fraudulent hedge funds, like Bayou, do exist.) But if you're investing with a hedge fund or a fund-of-funds which outsources its investing, you can have no such peace of mind. As Michael de la Merced says, the Madoff affair can -- and should -- erode confidence in hedge funds generally, even if Madoff himself was not technically a hedge-fund manager.