With everyone tsk-tsking the Madoff scandal — the amount lost, the after-the-fact obviousness, the SEC incompetence — I thought now was as  good a time as any to look at the actual research, due diligence and manpower thrown at investigating managers and funds.

Not surprisingly, it is tiny — at least, when compared with the heavy lifting of equity research. The asset management and brokerage industry is vastly under-invested in due diligence; the resources applied to hedge funds and managers is a comparative pittance.

Note that every major brokerage firm — from Merrill Lynch to UBS to Morgan Stanley to Credit Suisse and beyond — offer a platform to these managers. Their managed assets group, private wealth management, (even retail brokerage) have access to these funds and managers.

And the due diligence that’s performed? It would be generous to call it weak. I was vetted a few years ago, and the items I was prepared to answer questions about — an IRS stock option issue (now resolved), a bankruptcy (someone with a similar name, not me), a few dumb items on my credit score — never came up. I was stunned how superficial the process was.

There have been more mutual funds than equities for a long time. A variety of firms, most notably, Morningstar, devote lots of resources and manpower to analyzing these funds. There are now more hedge fund managers than there are US stocks. Throw in the biggest of the individual managed account firms (like Madoff’s) and its significantly bigger.

Yet the research, resources and manpower dedicated to investigating the managers and hedge funds is a pittance of what’s applied towards researching just the S&P500 equities.

Consider these data points: The typical big firm covers at least half of the S&P500 equities. Usually, there are 3 separate divisions that do so: Asset Management, Investment Banking, and Institutional Trading. Due to compliance rules (Chinese Walls, Spitzer rules, etc.) each does a very different form of research. The research can be long-term investing/asset management focused, or it could be geared towards iBanking, or it might simply be institutional trading. This often means some bigger firms have more than one analyst covering the same individual stock.

One firm I am familiar with — let’s use a range to avoid identifying them specifically — has this headcount:

  1. Wealth Management Research: 50-75
  2. Investment Banking Research: 300-400
  3. Institutional Trading: 150-200

Let’s assume half of these people are analysts, and the rest are admin/marketing/sales.

How many people do you think they have vetting the 250-500 hedge fund and individual managers on their platform?

Under 10.

I surmise this ratio — somewhere near 25 to 1 — is typical throughout the industry.

If you want to know why a sociopath like Madoff slipped through the cracks — as an industry, we do not dedicate enough resources to vetting managers.



Credit Suisse Urged Clients to Dump Madoff Funds IN 2000
Credit Suisse Group AG, whose clients lost almost $1 billion in Bernard Madoff’s alleged swindle, urged customers more than eight years ago to withdraw cash from his firm because the bank couldn’t determine how he made money, said three people familiar with the matter.

Oswald Gruebel, who headed the private-banking unit of Switzerland’s No. 2 lender at the time, made the recommendation after meeting Madoff in New York in June 2000, the people said, speaking anonymously because the details were private. Credit Suisse customers proceeded to redeem about $250 million from Madoff-run funds, half the total held by the bank’s clients, the people said.

Category: Bailouts, Hedge Funds, Investing, Legal, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

32 Responses to “Vast Under-Investment in Due Diligence”

  1. carmen101 says:

    OK, so how realistic it is to do thorough due diligence of a hedge fund? Aren’t those funds private and not subject to a lot of disclosures as equities are? Is that why they don’t put so much staff to the vetting effort?

  2. I ma referring to those banks that put money into these funds.

    That is what due diligence is — we are not talking about pubic disclosures, this is about research and disclosures to your investors and limited partners

  3. Bob the unemployed says:

    > If you want to know why a sociopath like Madoff slipped throught the cracks — as an industry, we do not dedicate enough resources to vetting managers.

    If the industry cared about the integrity of those hired for management, then the due diligence resources would be available.

    I am yet to be convinced that the industry wants the level of due diligence that is needed.

  4. VennData says:

    It’s an optimization problem for industry. Politically, they fight and fight, and try to gut-feel the value for the money they spend lobbying and hiring the castoffs (it’s a shame so many good Bush appointees from Pat Robertson’s Liberty University will be on the dole. Will teach them something about public assistance thought.)

    The fact is, financial industry regulation could be computerized to a great extent. Statements to clients cross checked to trades… cross checked to bank account balances etc. The fact that we only recently have XBRL in filings and still rely on people to honestly do their Schedule D’s is comical.

  5. danm says:

    I agree Barry:

    But our entire financial system is standing on shaky foundations. When the base is not solid, how can anything else work?

    For example, government has been transfering pension saving onto the shoulders of individuals without even making sure the market was even deep enough to withstand the increasing amount of dollars pouring into the market.

    I did a quick back of the envelope calculation. If every Canadian was saving the approriate amount for their retirement and had the age appropriate amount saved up to generate 20K revenue stream at retirement, our Canadian equity market would have to be around 2 trillion dollars. The last I checked, it was under 1.6 trillion and that included penny stocks.

    Ironically, investment advisors are pushing investors into holding more and more equity because history has shown that equities do better than fixed income (which is false over the last 2 decades).

    If every Canadian had been adequately saving for retirement, wouldn’t economic growth have been smaller, thus making equity markets even more shallow?

    Every investor out there is looking for the best manager but everyone summed up IS the market, and we know that 50% will underperform and 50% will overperform. What do we have to say about a pension system that fails 50% of its people from the start?

  6. danm says:

    So if our leaders are illuminated and really understand all these issues, that means they are banking on most people failing to save for retirmement.

  7. constantnormal says:

    This seems (perhaps not surprisingly) similar to the lack of checking that went on in the mortgage industry — except the lack of due diligence there was more of a recent aberration, while in the securities industry it is my feeling (just a hunch, no data to base it on) that this is the way it has always been.

    Does anyone with experience in the business recall a time when actual due diligence was performed, or was it left up to the (now-toothless) SEC?

    But this lack of due diligence extends beyond the “professional” money managers — how many individuals do even the simplest things when deciding what funds to put their IRA or 401-K money into? How many actually check to see what the fees are, the fund manager’s tenure, how well the fund has done in down markets vs up markets, or for that matter, how many use performance as a metric at all?

    This is why index funds are the best idea for most people, but even then there is usually a choice of index funds (S&P 500, Russell 2000, etc), and how many people bother to compare the choices available?

    People are apparently genetically constrained against combining thought and action.

  8. danm says:

    In Canada, women they got the vote, not because it was fair, but because the Liberals wanted to win and they knew women would vote liberal. Did the men like it? Not really but who cares about the long term impact, we want our liberals in power NOW! We’ll deal with the women later.

    I think the evolution of our markets are somewhat similar. No great thought was put into it, it just got shaped into what it is with each passing event. No one really sat down and thought about whether or not it made sense to promote Freedom 55 to our Boomers or to put people with 100K, 75% in equities.

    The indutrialists owned the wealth and as growth stalled, it just made sense to let the proles into their equity game. Hey, that meant reducing their taxes (because they did not have to fund SS as much as they would have had to) and having the underlings boost valuations every time they bought some funds. A win-win.

    Ironically, many who see through this are the “non MBA” blue collars. I’ve been renovating my house, and each time I talk about markets with them I’m amazed to see how much they know. Many of them see through the charade.

    The ones who’ve bought into the system are the white collars. I guess, deep down, they always hang on to the hope they’ll make it up the latter and get those options.

  9. Mannwich says:

    I worked inside a “white shoe” private bank a few years back and can say without a doubt that most of the focus was on hiring new business developlent/sales people who could bring in new client assets, as opposed to hiring research people. This is no surprise at all. It was and is still always about bringing new client assets (which translate to beloved “fees”). Not nearly enough attention was/is paid to research, although I did recruit investment management research analyts as well.

    Also, it is my understanding that several of the investment management research firms out there have similar conflicts of interests that the ratings agencies have/had throughout this mess.

  10. dead hobo says:

    Whoa, bro. It’s not cool to second guess the movers and shakers in the office. It’s also very uncool to criticize those with personal wealth. They only got that way because they are better than you and mistakes are not a pert of their vocabulary or lifestyle. Don’t make me roll my eyes or sigh at you.

    If you’re a hedge fund manager, all you need to remain infallible is a winning personality and a great web site. A few good slogans are also key, since they define you. Due diligence only cuts into profits from management fees. And contracts that specifically mention, IN CAPITAL LETTERS, matters that pertain to risk of various sorts is all you need to protect yourself from all those things that only happen to people who aren’t as smart as you. That and good hair and an inspiring sales pitch.

    You want to be the object of derisive gossip at lunches you don’t get invited to? Just mention risk and other braniac things. You may as well be talking common sense and simple everyday logic to a quant. They won’t want to have anything to do with you either. These people get the good offices because they can easily substitute personality or ‘mathy talk’ for real work.

    I repeat, there are no mistakes here. Only the effects of misfortunes that were completely out of control and completely unforeseeable. It’s somebody else’s fault.

  11. constantnormal says:

    VennData @ 8:25 — “The fact is, financial industry regulation could be computerized to a great extent.”

    After over 30 years in the IT industry, I find that nearly everyone thinks of computerization as a substitute for understanding, and believing in “the system” replaces a healthy questioning of the data, and how the results were obtained. If anything, automated systems require even more ongoing checking and followup than manual systems, for while they can do a lot more work without random mistakes, it does not mean that random mistakes — or even 100% wrong actions — cannot occur, as conditions change and rigid automated systems fail to adapt, and the torrent of results rapidly becomes a torrent of garbage. I would guesstimate that at least 10%-15% of the automated business systems in existence today are regularly churning out 100% nonsense, with either the ground rules they were written under having changed without the systems having commensurate changes, or the systems were changed and the operation was never properly tested following the changes.

    Almost always, when an automated system takes over work that a group of people used to do, there is no ongoing verification or validation of the system’s operation, beyond whatever is done to approve the initial launch.

    Of course, there is an expression, predating computers, that perfectly describes this attitude:

    “If it’s not broke, don’t fix it”. And therein lies the rub.

    Looking back at this mini-rant, I see that one might think that I am some sort of neo-Luddite, opposing automation. Not at all — I merely note that in a successful automated system implementation, the “subject matter experts” who understand how the system is supposed to be operating, should be charged with performing spot checks (a.k.a. “quality control”) on a continuing basis, looking for breakdowns in the operation of the automated system. I am not referring to the programmers here, but rather the people who understand the data flows (which may well be the programmers, but ought to be from among the people being replaced).

    By and large, this almost *never* happens, and we wind up with large automated systems, running essentially unattended, grinding out their original purpose with mechanical perfection, regardless of how that purpose changes over time. Unattended automated systems are merely automated disasters waiting to happen.

  12. Mannwich says:

    @constantnormal: I would also add that over-automation tends towards even LESS individual human accountability (similar to the corporate structure as a whole).

  13. Mannwich says:

    @dead hobo: So sadly true, which is why I took myself out of that game a couple of years ago vowing never to go back. Have to admit, much of this implosion is a tad amusing to me on a few levels (fascinating on others and horrifying on others) but the problem is the people who most deserve the commeuppance still won’t get it. They’ll just reinvent themselves, hop on the new gravy train and do it all over again. It’s how our country “works” (or doesn’t work) right now and everyone knows it.

  14. Scott F says:

    Just reading something I’d forgotten about wrt the SEC—don’t know if you mentioned it, or have time to fit it in somewhere. But google Gary Aguirre and John Mack. He was an SEC lawyer investigating Mack, and was I believe disciplined and then fired. David Kotz, SEC’s own inspector general, found officially that he’d been correct in attempting to interview Mack on the subject of insider trading. Mack was a huge W supporter, Pioneer fundraiser, I believe (as was Stanley O’Neal), and there were strong suspicions that his political connections got him bigtime preferential treatment.

  15. deanscamaro says:

    And Dubya was pushing self-directed retirement funds. We were lucky, as a general population, that there were enough knowledgeable people around that his idea was laughed out of the room. With an industry that is mostly show and selling themselves for their own gains, the common person trying to grow their earnings into a retirement nest egg doesn’t stand a chance. Advisors are there to sell their own companies products and programs, no matter what their performance and not to perform any due diligence that small investors can benefit from. And from the personal greed demonstrated out there lately, the small guy probably only has the CD’s and money funds to depend on for his goals for the future. A sad state and why government retirement programs will become more important.

  16. Imelda Blahnik says:

    Re: There have been more mutual funds than equities for a long time…There are now more hedge fund managers than there are US stocks.

    Is that hyperbole, or fact? If the latter, that blows my mind.

  17. riley says:

    >Bob the unemployed Says: I am yet to be convinced that the industry wants the level of due diligence that is needed.

    Exactly. It is not about a lack of due diligence but rather doing the due diligence to support your sales force? Unfortunately performance is the only metric too many investors use. If investors are going to buy performance it is easier to have a manager such as Madoff on your platform than it is to try and explain to a (potential) client why your firm is not using him. If a firm does not have access to a manager, rather than listen to the reasons why, performance chasing investors will just go down the street to a firm where that manager is available. Investment firms want to approve a manager such as Madoff. His reported returns are an easy sell.

    >constantnormal Says: Does anyone with experience in the business recall a time when actual due diligence was performed, or was it left up to the (now-toothless) SEC?

    Real due diligence was performed regarding Madoff. It has been reported that that Aksia LLC, Alpha Capital and Doug Kass advised clients not to invest with Madoff and that in 2003 Societe Generale refrained from buying a business with exposure to Madoff’s funds. Clients who paid for real information seem to have benefited. Those who paid for performance …….

  18. David Merkel says:

    From my own experience, the guys who do do the due diligence on fund managers are not the “A Team” within their organizations. They usually haven’t been successful fund managers themselves, and they are usually slaves to some form of MPT, without the econometric knowledge necessary to analyze the residuals (i.e. are they too good to be true?).

    The same applies to many, but not all fund of funds managers, and yes, I was once in that business back in 1994-1998. It’s relatively easy to analyze past performance quantitatively, but harder to demonstrate that the results flowed their process rather than happenstance. I did okay at it, but learned that it was an “easier said than done” business.

  19. Mannwich says:

    @David Merkel: That’s true and it may sound “squishy” but due diligence should also be conducted from a “qualitative” standpoint as well. That’s what was/is missing in much of today’s investment management due diligence and research.

  20. rogerdaily says:

    Well, it should be clear as day that most of the hedge fund business is about raking in fat fees. So, why the big surprise that Madoff happened.

  21. riley says:

    @deanscamaro- Talk about a Ponzi scheme. Compared to the Social Security Ponzi scheme the government is running, investor losses from Madoff are nothing. In 2005 Social Security, Medicare and Medicaid spending accounted for more than 40% of the federal budget. When there are fewer people paying into social security than are receiving benefits, where is the money to pay those IOU’s going to come from? The government’s return on their “investment” in the auto industry.

  22. do you/FusionIQ lay off any of your Clients’ cashish to other ‘Mgr.s’?

    or, do y’all ‘roll’ everything in-house?

    some firms have different m.o.’s, no?

  23. Moss says:

    Hedge Funds, Mutual Fund Companies, Wall Street firms and the like are compensation conduits for the principles. If one thing has been unearthed by this meltdown it is that the individuals monetary interests trump any other concern. What was the name of that book? ‘Where are the Customers boats’? I am utterly disgusted by the depth and width of the corruption that has surprised and astonished the unsuspecting. I for one have always been a skeptic of the so called ‘professionals’ associated with ANY financial institution.

  24. Fred C Dobbs says:

    I fail to see why you were stunned. Is it because you see through rose-colored glass? It is not possible, let alone practical, for big, central government to absolutely protect you from becoming a crime victim. It is unable to detect all criminal intentions in advance. It has to wait until the criminal identifies him/herself by taking some criminal action. At a minimum, it would take more than 4 people taking turns working 40 hour weeks to guard you 24×7 standing at your side. In other words, 80% of society would be employed protecting 20%, while being unprotected themselves. Who would feed, clothe, and house both the protected and unprotected? It is silly to suppose any government is going to protect you absolutely from being the victim of a physical crime. That is why there is a 2d Amendment. We must be prepared to protect ourselves. It is the same with non-physical crime. People lie all the time. That is why the saying ‘Caveat Emptor’ (Buyer Beware) is ancient, and not something new. And when they lie to gain a financial advantage, they commit the crime of fraud. Reagan is credited with saying something to the effect that is is good to trust, but it is better to verify. Investment advisors deal directly with people with surplus money, money they don’t need to pay bills, and can be ‘invested’ (gambled). These monied people didn’t get their hands on this surplus money from being lazy, and dumb, but through the use of effort and intellect. What makes them so special that they deserve special government protection? Why should government assume the responsibility for performing due diligence for these active, smart, successful monied people? Why should it be free, at taxpayer expense? And should government make a mistake, why should a jury award these people money collected from taxpayers? If they could not or did not verify, and proceeded to gamble with Madoff, they deserve to loose their money. The gamble includes the character of the person with whom you entrust the money, that he will honestly place your bet. There is no reason to suppose that the money they invested would not have been lost in the market had they given it to someone else who was honest but merely stupid, rather than crooked. If one wants to protect oneself against financial crime (dishonesty), one needs to verify first that one’s funds are being entrusted to a solvent defendant. One should also periodically verify the funds are still with a solvent defendant. The easiest way to verify this is to demand return of a large portion of your investment from time to time. There is no evidence that any of those who invested with Maloof relied on actual knowledge of what the SEC did or did not do. Those who invested in Madoff deserve nothing, and have no right to blame government, since they failed to exercise common sense.

  25. phb says:

    Try this on for size – the investing public has lost their confidence in the public market system (ie exchanges, funds, brokerage houses, banks, etc. ad nausum) therefore they search for alternatives to “the system” and seek out private investment opportunities. Barry makes reference that there are more Hedge Funds than publicly traded stocks, this is no coincident. We are at a point of inflection in history with change underway. Either proper regulation to insure investor confidence is restored, or we move on to a new form of “capitalism” that has yet to be defined. I personally believe that the toothpaste has been violently been squeezed from the tube and therefore we are moving to a new world.

  26. Todd says:

    @Fred C Dobbs
    I for one will keep wearing my Nihilist glasses and keep doing what I’ve always done. Besides I like the color black. I hear swans come in that color too. ;)

  27. David Merkel says:

    @Manwich — I agree about the qualitative part. I ferreted out some bad managers that had good track records, and that could only be done by qualitative work. Most of my analyses were qualitatively-driven, but had quantitative work as well.

  28. usphoenix says:

    What’s the old saying, “you can’t legislate values”? Due diligence has to be an internal thing, and it has to be performed as a value by the deal-maker, not the auditor. Internal auditor’s get blown off regularly. Legal? Hey, who wants to squirrel a sweet deal? Or leave a bonus on the table?

    The situation is incredibly simple. Greed trumped trust and integrity. When you can bank $20 mil in one year, who cares about trust? Unless you’re trying to compete with Bill or Warren? Or $20 mil isn’t enough to support your lifestyle for as long as you plan to live.

    Exactly how many have gone to jail that should have?

    The social fracturing and value deterioration is just peaking, that’s all.

    The fat cats walk, sign off, and leave it to the feds (us) to fund. LOL.

  29. TO says:

    Work with one of the three largest private wealth managers in the business in this exact field….

    The analysis done on HF, HFOF, Real Estate, and PE is extremely buttoned up. Very thorough – I’m not just saying this bec. I work there. Considerable time spent on background checks, hours spent onsite with numerous firm personnel, balance sheets scrutinized, separate people doing operational DD versus investment DD. It can take months to have a manager approved, wherein lies the problem – more in a bit. Various committees filled with risk and compliance must sign off on any new manager. The level of quantitative “econometric” analysis done is limited – build all the models you want, the returns are still in the past. 80-90% of the work is qualitative. While there have been no major problems – some minimal exposure in FOHF to Madoff and a few prior implosions – Sowood is one that comes to mind, regardless very minimal. The real conflict lies with advisors demanding more products, and demanding them quickly, with threats to leave the firm attached….which has the potential to lead to missing something……

  30. Scott F says:

    Having been involved with due diligence, I can tell you why.

    - If they want the deal done, dd is cost.
    - If they don’t want the deal done, it only takes one or two people to find the way to kill it.
    - If things go wrong, it is the unsecured partners, read retail investors, who take the bath.

    SED (Squid Est Demonstratum – or you’re fried.)

  31. bcasey says:

    Phb I love the toothpaste analogy.

    Due Diligence omfg where do you get these terms?

    A whole heck of a lot have gotten jacked on this one, But guess what, it just goes to show, New York is a whole heck of a lot like Detroit, just New York has more bottom feeders…

  32. bcasey says:

    Or maybe bigger bottom feeders would be more apt?