Posted on December 25, 2008 - by Jeflin

Only In Bad Times Do We Know We Is Swimming Naked

Photo by erix!

Financial course fees for investors are getting ridiculously expensive. In the Lehman Brothers debacle, some investors parted with their life savings to learn complex financial terms, like collaterized debt obligations, derivatives, credit default swaps, first to default, credit linked notes, etc.

Next lesson up is about ponzi scam – where early investors are paid outsized returns from the commitments of new investors. Bernard Madoff, former NASDAQ chairman ran a $50 billion fund where annual returns of over 10% were paid to his clients in a ten-year period.

Those in the fund management industry should know that consistently beating the market is nothing short of miraculous. Investors were either in the hands of a genius or a fraudster. As it turns out, the financial tsunami which decimated Wall Street called time on Madoff’s scheme.

New clients began to dry up while Madoff was forced to pay massive redemptions when clients withdraw their cash. He finally confessed to prosecutors that he “paid investors with money that wasn’t there” and there was “no innocent explanation” for his behavior. “It’s all just one big lie” and that it was “basically, a giant Ponzi scheme.”

Well done, I give Madoff credit for having the spine to own up to his crime instead of feigning ignorance, blaming extraneous circumstances, shifting responsibility to regulators or investors who failed to conduct their due diligence. However, being a long-standing leader (since 1960) in the financial services industry, his indictment is scant consolation for heartbroken investors staring at worthless pieces of paper.

Trust in the entire $1.6 trillion hedge fund industry is now destroyed. Investors threw their lot behind hedge funds because, as the name implies, the fund mangers hedge their risks prudently and are sophisticated in their selections. Hedge funds that invest in other hedge funds, also known as “fund of funds” are considered even safer due to diversification of risks.

They won investors over with portfolio diversification and meticulous due diligence into other funds’ management and investment strategies. Their fees are not cheap, usually 2 percent, and they get a cut of the profits that can reach 20 percent, easily earning them billions of dollars in profit per year. Read more…

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1. Portfolio Management
2. Diversification
3. A Super Return Fund?