Financial Forensics and Made-Off Scandal

Several readers have offered comments about signals they deem could have and should have been indicators of trouble. Adding to our January 13, 2009 list ("Madoff Red Flags" How Many Can You Count?"), the tally now includes:

  • Regularity of returns despite market volatility
  • Complex strategy
  • Poor transparency about performance reporting standards
  • Unknown audit firm
  • Seemingly limited due diligence by some parties
  • Unclear assignment of investigation-related duties (knowing who does what)
  • Questionable diversification
  • Few questions asked about risks
  • Limited internal controls, if any
  • Lure of "movie star" reputation
  • Limited attention paid to hedging efficacy
  • Limited knowledge of rebalancing techniques
  • Limited knowledge of trading limits and stop loss points
  • Limited knowledge of collateral risk
  • Unclear understanding as to who played the role of fiduciary
  • Limited knowledge about asset valuations and related valuation process
  • Absence of an independent custodian to safe keep assets
  • Analysis of option open interest and trading volume activity that would have shown "bad math" (reality versus alleged activity on the part of Madoff affiliates).

According to "Risk test study of Madoff claims" by Anuj Gangahar (Financial Times, January 21, 2009), a bias ratio computation could have likewise shed light on what is now accepted by most as the largest financial scandal in modern times. Believed to be akin to a test for randomness, the bias ratio is "a mathematical technique that identifies abnormalities in the distribution of investment returns." (I wrote about the bias ratio in "Hedge Fund Returns - Illusion or Fact?" on July 15, 2007. Riskdata is releasing a study today on their findings.)

Gangahar likewise mentions something called Benford's Law, a comparable method that is used by forensic specialists to detect accounting fraud. According to "I've Got Your Number" by Mark J. Nigrini (Journal of Accountancy, May 1999), a physicist named Benford discovered that "numbers with low first digits occurred more frequently in the world." Applied to Madoff, observations made by this 1920's GE employee could infer that sustained steady growth would have been highly improbable. (Paul Kedrosky, author of "Infectious Greed" seems to debunk the value of Benford's Law as applied to Madoff returns. See "Bernie vs. Benford's Law: Madoff Wasn't That Dumb," December 19, 2008.)

Editor's Note: Keep in mind that underlying assumptions for any mathematical technique that is used to detect fraud and/or lack of randomness must comport with reality. In the Madoff situation, an option strategy referred to as a "split strike conversion" was heavily relied upon. It would be helpful to know if any Madoff-related risk analyses took into account the asymmetry of historical statistical returns for this option collar technique.

Hedge Fund Returns - Illusion or Fact?

 

Financial News reporter William Hutchings writes that more than a few hedge funds trading in "illiquid" securities engage in smoothing of returns. Citing research conducted by his firm, RiskData CEO Olivier Le Marois says that "instead of following a mark-to-market process to price securities based on what the market is giving for the securities, they are implementing a subjective process of evaluation." While an independent third party could objectively provide an opinion of value or vet the process in place, smoothing empowers the portfolio manager to decide "the value of the securities he is trading." As an aside, for those who invest in hedge funds, consider how many Private Placement Memorandums give a manager full discretion over what and how often positions are valued. (Click here to read "A third of funds hide their true volatility" by William Hutchings, Financial News, July 12, 2007.) 

RiskData earlier announced that they would market something called the Bias Ratio. Developed by one of their fund of hedge fund clients, Protege Partners, this approach examines "month-to-month changes in net asset value" against various statistical return patterns, by asset class. (See "Risk Manager Markets Method To Monitor Hedge Fund Results" by Michael A. Pollock, Smart Money, July 3, 2007.)

On June 27, we wrote that the SEC intends to query hedge funds about their approach to valuing "hard-to-value" assets. Given recent headlines about billion dollar value mistakes, can pension fiduciaries afford not to ask tough questions about process? We repeat what we said then. "In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!" (Click here to read "SEC Announces Investigation of Hedge Funds' Valuation Methodologies.") 

In the event that a pension fund hires a consultant or fund of funds manager, are they digging deep into valuation issues? Can they? (As an accredited appraiser, I can vouch for the rigor of training and experiential requirements as regards valuation.) If they don't "own" the valuation oversight duty, who does? At a recent hedge fund valuation workshop I co-led, a colleague read from a fund administrator's client contract, highlighting the section that disclaims responsibility to vet valuation numbers provided by the hedge fund. You often find similar disclaimers from prime brokers and custodians, forcing pension funds to ask - "Who is paying attention?"

If true that valuation numbers from hedge funds are passed through the hands of multiple parties and no one is asking rigorous questions about their quality, aren't pension fiduciaries greatly exposed to liability? The issue is made more complex when various service providers such as consultants play the role of fiduciary.

Answers to questions about valuation should be more than an optical illusion.