Last year, hundreds of hedge funds, special mutual funds generally open to wealthy investors which specialize in alternative investments like derivatives, shut down due to the economic crisis. Three of the ten largest hedge funds to close were funds that invested exclusively or almost exclusively in Bernard Madoff’s Ponzi scheme, leaving investors with nothing. While I mention that hedge funds are investment vehicles for the rich and famous, it’s worthwhile to note that you don’t have to be rich to be affected by this. 971 employees in Connecticut, for example, are feeling the same pain wealthy clients like Steven Spielberg and Jeffrey Katzenberg feel because their pension funds were pooled together and invested, much like one wealthy client, in Madoff’s funds.
The lack of diversification played a roll for individual losses. But how much is the fault of the investors? Presumably, the firemen in Fairfield are not given any choices for their pension fund. Also, hedge funds promise or at least imply diversification; this is how investors “hedge” their bets. An investor in a hedge fund would then assume that although the money is held in one and managed by one individual, that individual is sufficiently providing the diversification they promised.
In the case of the feeder funds, the hedge funds invested almost exclusively with Bernie Madoff. This extra middle layer passed the responsibility of diversification on to Madoff, who was never sufficiently clear about his “investments.” Of course, we now know that there was no “investment” and thus no diversification.
How well are your investments diversified? Is it enough for a investors who has weighed risk against potential reward to diversify among stock investments, like large-cap, small-cap, international, etc.? Do you rely on one mutual fund, like an index fund or a target retirement date fund to handle your diversification? Are you diversified into precious metals, and are you satisfied with using exchange traded funds or do you own gold or silver in physical form?
Typical investors can at least trust that a mutual fund in their portfolio does not lie on the prospectus. But when you invest in a hedge fund that is supposedly diversified, how diversified is it?
Three of the largest hedge funds to fail last year, Fairfield Sentry (managed by Fairfield Greenwich Group), Rye Investment Management (managed by Tremont Group Holdings), and Kingate Global Fund (managed by Kingate Management), were Madoff feeder funds, designed to provide access for “smaller” wealthy investors to the exclusive Bernard Madoff. Investors trusted their financial advisers who suggested the invest in these hedge funds. Thse advisers trusted the hedge fund managers who in turn trusted Bernard Madoff, one person, to provide sufficient diversification within his secret “investment” scheme. Or perhaps “trust” isn’t an issue when reputation and the promise of sustainable, high returns is involved.
A Look at the Hedge Funds That Closed, New York Times, March 19, 2009
Updated September 17, 2011 and originally published March 19, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.