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Practitioner Viewpoint

Simple Way To Avoid the Next Madoff

By Walter Gallwas*

It's easy to say investors should have done more due diligence before giving their money to Wall Street veteran Bernard Madoff, whose $50 billion alleged Ponzi scheme continues to grab headlines. Crooks figure out how to stay one step ahead—more due diligence, questions asked and regulations lead to ever more elaborate schemes. If a smart man like Mr. Madoff really wants to deceive people, he finds a way.

One easy solution is often overlooked in the discussions on how to avoid fraud. It's like the old story about the man who goes to the doctor to complain that it hurts when he moves his arm a certain way. The doctor replies: then don't move your arm like that. If you are concerned about fraud when investing in privately offered funds, then don't put your money into a fund structure. Instead, use individually managed accounts.

It happens that one of the few asset classes enjoying gains this year, managed futures, is also a pioneer in individually managed accounts. These are accounts in the client's name, managed by someone else. The manager places trades directly into the client's account, reviews the balances and positions in that account, and adjusts the positions for that specific account. The checks go to the clearing firm, the client controls the money, and the manager only controls the trading.

By contrast, when you invest in a pool, your money becomes part of the fund and you own a share of the fund's total assets. The manager places trades in a single fund account – not the individual accounts of hundreds of investors – and reviews the positions for the overall fund. He or she controls the fund and has the ability to write checks on the assets.

Not to be too cynical, but a manager could decide to cash the whole fund out and head to the Caribbean, if so inclined.

Fund Hazards

That's not all. Fund structures have other risks, not related to investment strategy or markets, that separate accounts do not have. There is redemption risk, as became glaringly apparent in 2008 because of the huge net outflows from hedge funds.

When a large portion of a fund's investors ask for their money at the same time, the liquidation of portfolio positions causes unexpected losses that can lead to further redemptions, further losses and so on in a downward spiral. Funds usually attempt to prevent this problem by limiting redemptions to certain periods or in some cases not allowing redemptions until the withdrawal requests can be matched with available assets.

With an individually managed account, by contrast, there is no effect from other investors leaving the program. An investor looking to cash in her investment merely has all of the positions in her separate account liquidated and the cash sent to her. There are no duration or asset mismatches to deal with.

There is also transparency risk to consider. An example is the blowup of Amaranth hedge fund two years ago. The fund lost around $4 billion trading natural gas futures. It was supposed to be diversified yet was concentrated in a simple bet on natural gas price spreads. Investors did not know how concentrated Amaranth's portfolio had become because there was no transparency.

Funds lack transparency by design because managers – typically concerned about their strategy being imitated or taken advantage of – do not want the public (and competitors) to be able to see what's happening in the portfolio.

Individually managed accounts, on the other hand, are set up in a way that allows you to see everything that is going on in your account day by day. This insures that there will be no big surprises like 80% of your account turning into a bet on the price of natural gas. If something strange is going on, you will be the first to see it.

It is one thing to lose money because a manager traded poorly or market conditions were adverse, quite another to lose because a manager did not match investment duration with redemption structure, put all the money into one huge bet, or committed fraud. Due diligence aims to identify non-investment risks so that you can separate those from trading risks.

Separately managed accounts achieve that goal, whereas due diligence can fail to do so, as we saw in the spectacular Madoff affair.

Futures Advantage

Now, proponents of funds may say that while individually managed accounts are great, the minimum necessary to have an advisor manage your specific account is too high. The fund structure, they might say, is the only way for smaller investors to get access to trading strategies which may require hundreds of millions of dollars of capital.

They do have a point—you can't do merger arbitrage, statistical arbitrage, or private equity deals with an individually managed account unless you have around $100 million in the account. An insistence on having your own account would keep you out of plenty of very good hedge funds.

But most good hedge funds have too high a price tag anyway. Perhaps if you can't afford to do it in your own account, you shouldn't be looking at that type of investment in the first place.

That brings us back to managed futures and individually managed accounts. Unlike hedge funds with their large minimum investments, there are quality managed futures programs where you can invest using an individually managed account with minimums as low as $50,000—such as Clarke Capital Management.

With managed futures you get affordability and the protection of individually managed accounts. The protection means you don't have to worry about the fraud, redemption and transparency risks associated with funds. The manager does not have access to your money, other investors' redemptions don't affect individual accounts and you can see all the trades put on for you.

Bad things can still happen in an individually managed account, of course. A manager could put on trades inappropriate for the agreed-upon strategy, say. But such problems can be identified early on, before they progress.

That way, you won't learn from news headlines that your investment is wiped out due to fraud or positions you had no idea you were in.

* Mr. Gallwas is president & founding partner of Attain Capital Management, a specialized asset management firm that focuses on alternative investments such as managed futures programs.