Institutional Investor's Alpha Magazine - February 2009 - (Page 56)

Unhedged Commentary Moving on from Madoff BY JOHN GODDEN he hysteria around hedge funds had only just begun to subside — and their status as public enemy No. 1 been taken down two notches, behind banks and politicians (and level with trafﬁc speed cameras) — when along came Bernard Madoff ’s admission that he had not been entirely straight with his investors. What seems to have confounded the wider public is the way in which presumably smart, careful investors were willing to suspend their regular due diligence processes and place huge sums of money with one man entirely on trust. Even if Madoff had been playing it straight, this would have been foolhardy. Why then has the hedge fund industry, almost uniquely, continued to invest client money in fund vehicles that ignore most if not all standard controls? Even money invested with honest managers typically has been placed on the basis of trust rather than as part of any systematiccontrol structure. The argument that has maintained this situation is that hedge fund managers and the techniques they employ are so special that they can work only in an environIN THE W AKE OF WHAT ment where a manager COULD BE A $50 BILLION has total control over all PONZI SCHEME, HEDGE aspects — investment decisions, valuation, reFUND INVESTORS SHOULD porting and fees. But in a INSIST ON INDEPENDENT world where governance MANAGED ACCOUNTS. is probably the most critical issue facing hedge fund investors, this argument is at best outdated and at worst criminal. Although the losses of 2008 might have sufficed, a seismic event such as Bernie Madoff ’s alleged $50 billion Ponzi scheme was probably needed to shock hedge fund allocators out of their malaise on governance and force them to start taking issues of appropriate accounting and custody seriously. What will it take for the hedge fund industry to grow stronger post-Madoff, similar to the way in which it grew stronger following the near-collapse of Long-Term Capital Management a decade ago? First, the industry must adopt — and be seen to adopt — a high-standard infrastructure that places the responsibility, power and control of all assets in the hands of an entity independent of the managers. Independent managedaccount platforms would allow for the administration, T custody, risk control and valuation of fund assets to be handled by a central set of entities on behalf of investors, not managers. Separating control of the funds from fund managers is key to proper governance and ensuring that all nonmarket risks are neutralized. It has long been problematic to have managers control the governance of funds while also functioning as asset manager and recipient of fees. Undoubtedly, the governance of hedge funds will come more into focus, resulting in much greater powers for fund directors and trustees. Funds of hedge funds and other hedge fund allocators have been criticized for failing to ensure that all client investments meet appropriate standards of infrastructure security, but their promises of high levels of due diligence and monitoring are undermined by their giving too much control over valuation, reporting and custody to managers. Only by fully separating these functions from the fund manager can the implied duty of care be properly fulﬁlled. The managed-account-platform model has long been seen as representing the best practice for fund structures, with an entity entirely independent of the manager controlling liquidity and trading arrangements. The continued discomfort experienced by some managers with this format in some ways indicates their reluctance to surrender the total control they currently enjoy. However, in light of the Madoff affair, we are certain to see most serious hedge fund allocators taking steps to deliver proper standards of governance by setting up their own managed-account platforms with single independent administration and a closed environment that prevents misrepresentation, misvaluation, misappropriation and fraud. Those investors with insufficient scale to set up their own facilities will utilize an independent managedaccount platform. Although these systems do not solve the problems created by a liquidity crunch, they do provide for full transparency and structural integrity, avoiding the problem of surprise. Employing these structures will help prevent a repeat of some of the problems that afﬂicted the hedge fund industry during 2008. John Godden is CEO of IGS Group, a London-based advisory ﬁrm that specializes in product design and portfolio construction, market positioning and distribution for hedge funds, funds of funds and service providers. 56 • INSTITUTIONAL INVESTOR’S ALPHA • FEBRUARY 2009

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - February 2009

Institutional Investor's Alpha Magazine - February 2009 Contents Letter From the Editor Longs & Shorts Digging Out A Call to Mentor Dicey Detroit The Constant Skeptic Cover Story: The Undaunted What Were They Thinking? Dark Days in Greenwich True Stories from the Commodities Files Return of the Native The Quest for Cover Moving On from Madoff

Institutional Investor's Alpha Magazine - February 2009

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