Bernard Madoff is in jail and hedge funds with exposure to his $50 billion Ponzi scheme are out of business, but questions continue to dog the industry’s due diligence measures, or lack thereof.
This week, FINalternatives spoke with Joe Gieger, GAM's managing director for the Americas, about how the $39.2 billion asset management firm’s due diligence process led to its rejection of Madoff’s split/strike strategy, and why he feels that investors are now better served by funds of funds than ever before.
FINalternatives: GAM had the chance to visit Madoff’s operations early on and decided against investing with him. What red flags led the firm to pass on the supposed ‘great investment opportunity’ at the time?
Gieger: We reviewed him twice; Once in 1998 when David Smith, chief investment director of GAM’s fund of hedge fund group, who at the time was an analyst, went to visit him. The conclusion of our meeting at that point was that we couldn’t triangulate the investment return that he was delivering with the investment strategy in which he was deploying. There was also very little transparency with respect to how he was arriving at the returns that he was generating.
So, [Madoff’s fund] never made it to our operational due diligence team because it never made it out of the investment committee to begin with. GAM has a nine-man operational due diligence team consisting of lawyers, accountants, and administrative professionals whom we employ prior to making an investment.
Then, in 2001, we made another attempt to better understand what was taking place in terms of the returns they were generating. Again, we rejected it because of transparency issues. There were technical questions posed to [Madoff’s firm] with regards to the options being used, and there wasn’t much transparency regarding the specifics of the stocks or how the actual returns were being generated. The link between their broker/dealer and investment adviser was also a concern for us.
FINalternatives: What made the firm revisit Madoff after rejecting his fund the first time?
Gieger: Part of our process is revisiting managers based on returns. If the returns are strong and attractive enough, we’ll look at them again. We look at up to 1,000 managers per year, and we typically invest in 5% to 10% of those managers. Even though we may not have an interest in a particular manager per se, we certainly need to visit that manager to understand the strategy that he is using so that when we’re looking at another manager who may be employing a similar strategy, we’ll get a better sense as to the types of returns that strategy can generate.
It’s almost like you don’t know what your apartment is worth in New York City unless you see another 20-30 apartments on the same floor and neighborhood as yours. So we’re not going to invest in that one strategy without understanding what his peer group is doing using a similar strategy. That’s why we’ll come back and visit [a manager] again to better understand the types of returns managers are generating.
FINalternatives: In general, what sort of transparency does GAM require, and get, from its managers?
Gieger: There are different levels of transparency we look for depending on the strategy. We’re getting position-level transparency from equity long/short strategies. When it comes to some of the less opaque strategies, managers there provide minimum level transparency to us including credit sensitivity indications, correlation sensitivities and interest rate sensitivities. It’s strategy specific and each manager fills out a template specific to his strategy.
Trading strategies are somewhat difficult as the strategies may not be in place for more than a day or so. Some of these managers trade currencies or options that may only be in existence for a few hours or days.
FINalternatives: Do you think the fund of funds industry will survive the Madoff scandal and become viable again in investors’ portfolios?
Gieger: Every industry goes through a period when the stronger managers survive and the weaker ones go out of business. I think you need the resources to do due diligence not only on managers, say, based in Connecticut, but also the ones in Australia, Hong Kong and London. This bodes well for some of the better funds of funds. Many institutional investors have realized the complexity of due diligence that is required when investing in hedge funds, and in some respects they have embraced funds of funds more so. We’re certainly seeing activity picking up among funds of funds searches.
The industry has also been somewhat vindicated because there were only a few funds of funds that ended up owning Madoff. There’s a lot of confusion in the situation with feeder funds, but these funds were never funds of funds to begin with. A lot of people get the two mixed up, but if you looked at it, you can count on one hand the number of institutional funds of funds that owned Madoff.
FINalternatives: After the kinds of returns hedge funds generated last year, do you think investors have lost their faith in an industry that touts absolute returns?
Gieger: I think it is almost a myth when you take a step back to say that hedge funds really performed that badly last year when you consider that the S&P was down over 37% and emerging markets were down 50%. Hedge funds were only down 12-13% during the same period…This year, hedge funds, in general, are up and the S&P is down some 13% year-to-date.
FINalternatives: Can you tell us about how the firm positioned its portfolio last year?
Gieger: Early on in 2008, we started with around 47% of the multi-strategy portfolio in equity long/short, but we ended the year with about 14% in these managers. In place of that change, we increased our global macro managers from about 26% to about 43%. We also maintained our arbitrage managers at a little over 25%. We’ll probably maintain this portfolio allocation for most of this year.
The average fund of funds last year lost about 22%, and we ended up losing only around 15% in our main fund of funds strategy. In our low volatility product, we lost around 11% last year and our trading portfolio was up over 6%.
We’re running about $16 billion in assets in our funds of hedge funds group and we turn over 15% or so every year in our portfolio—so, we’re always looking for new ideas and new managers. In general, we’re known for investing in newer managers. Towards the end of this year distressed/credit related strategies may begin to perform better.