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Avoid Madoff type scams with individually managed accounts

December 15, 2008

 

If you were able to turn on the television or pick up a newspaper over the weekend without hearing about the $50 Billion Ponzi scheme run by famous Wall Street veteran Bernard Madoff, consider yourself lucky.

If you have no exposure to this latest fraud case, consider yourself even luckier. The list of now broke millionaire individuals, fund of funds, charities, and others is shocking both in its magnitude and in the supposed sophistication of those who lost money. Maybe having a lot of money doesn’t necessarily make you a sophisticated investor as the US government says it does.

But we’re not as concerned about the who, why and the how ? There is already plenty of news material out on the internet covering those topics. Here is the link to the Wall Street Journal’s “Bernard Madoff page”:  http://online.wsj.com/public/page/bernard-madoff.html

We’re more concerned on how individual investors can avoid such scams. Short of hiring private investigators, full time due diligence staff, or simply hiding your money under your mattress and stopping any investment activity; what small steps can you take to protect yourself from being the victim of fraud?

Everyone is saying more due diligence should have been done, more questions should have been asked, and such – but at the end of the day, if someone is trying to deceive you they can and will go to great lengths to do just that.  It is a cynical view, but the crooks appear to always be one step ahead – with the more due diligence, regulations, and questions asked by their victims leading to ever more elaborate stories and schemes to conceal their true nature.

Individually Managed Accounts:

It seems that in all of the discussion on how to avoid fraudulent activity in funds, people are missing one easy solution, which is don’t invest in funds….. It’s like the old story about the man who goes to the doctor saying it hurts when I move my arm like this, and the doctor replies – then don’t move your arm like that.

The corollary is, if you are concerned about the “hurt” you can get when putting money into privately offered funds, then don’t put your money into such funds. Put your money into individually managed accounts instead.

It just so happens that one of the lone asset classes enjoying gains this year, managed futures, is also one of the pioneers in managing client funds through individually managed accounts.

Individually managed accounts are really no more complicated than what their name implies. They are accounts in the client’s name which are managed by someone else. A manager who accepts individually managed accounts will actually place trades directly into a client’s account, review the specific balances and positions in that account daily, increase and decrease position sizing for that specific account, and so on.

Contrast this with a manager who operates through a fund structure. In that case, the trades are placed in single fund account, versus the individual accounts of hundreds of investors. And the manager reviews the positions and balances for the overall fund only, not worrying about how much money a specific investor in the fund has.

Thus the difference between funds and individually managed accounts is not really a case of what they can invest in, but rather a case of how they manage each client’s money - either in the client’s individual account or through a pooled fund.

This difference leads us to one simple solution to avoiding fraudulent investments. That solution is choosing individually managed accounts over fund structures. When you invest in a fund – you are handing over your money to that fund, and putting your money in the name of the fund. Your money becomes part of the assets of the fund, with you owning a part of those overall assets.

With an individually managed account, you don’t hand over your money to a fund, you keep your money in your name, and your money does not become part of the assets of the manager you invest in (and in fact, it does not even become part of the assets of the clearing firm/prime broker used by the manger). Your money stays in a segregated account in your name.

With everything in the name of the manager, the risk of fraud exists due to the manager basically having check writing ability for the assets of the fund. He or she could decide to buy a new car or cash the whole fund out and head to the Carribean if so inclined (or do a Ponzi scheme as Madoff allegedly did). In contrast, the risk of that type of fraud is eliminated in an individually managed structure, where only the client has check writing privileges out of their account.

Now, proponents of fund structures will say that individually managed accounts are great, but the minimums to have an advisor manage your specific account are too high. The fund structure, they would likely say, is the only way for smaller investors to get access to trading strategies which require tens if not hundreds of millions of dollars in capital.  And they do have a point there, you really can’t do merger arbitrage, statistical arbitrage, or private equity deals with an individually managed account having anything less than $100 Million or so.

But the devil’s advocate in me would say - 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.

Additional Risks of Fund Structures

Because of these different structures, funds actually have several additional risk factors (not having anything to do with the trading style, markets their in, etc.) that individually managed accounts don’t have. These are the risk of fraud, redemption risk, and transparency risk.

We’ve covered the first type of risk – Fraud, in the paragraphs above. But the take away for people out there should be that in a fund structure, the checks go to the fund, the manager controls the money, and the manager controls the trading; whereas in the individually managed account structure – the checks go to the clearing firm, the client controls the money, and the manager only controls the trading. This means there are three separate entities involved, creating a system of checks and balances. Many hedge funds address this by enlisting a 3rd party administrator to control the money; but in the Madoff case there was just one entity (Madoff) involved in all three aspects.

Redemption Risk – Something which wasn’t readily apparent until the huge net outflows from  hedge funds this year (totaling tens of billions), redemption risk represents the issues brought about by everyone heading for a fund’s exits at the same time. Imagine a case where a trade which has duration of 1 year has to be exited prematurely to meet the redemption requests of people asking for their money right now, and you can begin to understand the risks of a large portion of a fund’s investors asking for their money at the same time.

If redemptions cause unexpected losses, they can lead to further redemptions, which cause further losses, and so on until there is a real problem. Funds usually attempt to control this mismatch by limiting redemptions to only certain periods (monthly, quarterly, or annual), or in some cases not allowing redemptions until they can match the requests with the available assets. In contrast, because an individually managed account is just that – individually managed – 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 individual account liquidated, and the cash sent back; no duration or asset mismatches to deal with.

Transparency Risk – this became very apparent in the Amaranth blow up two years ago, when a hedge fund lost around $4 Billion trading Natural Gas futures. The issue was that they were supposed to be diversified into much more than a simple bet on Natural Gas price spreads, but nobody knew how concentrated Amaranth’s portfolio had become because there was no transparency. Funds lack transparency by design, as the managers usually don’t want the public (and competitors) to be able to see what is happening “behind the curtain”.

Individually managed accounts, on the other hand, are designed in such a way that you can see everything that is going on in that account minute by minute and day by day. This insures there are no surprises like 80% of your account is in a Natural Gas trade. If something weird is going on, you will be the first to see it.

Conclusion

So where does this leave us? Should you never invest in a fund? That is up to you. Not doing so would insure you won’t pick up the paper one day and see your investment is wiped out due to fraud or positions you had no idea were put on for you. But not doing so would also keep you out of plenty of very good hedge funds out there which are legit and have nothing to do with the recent headlines.

But at the same time, the discussion of a fund versus an individually managed account is really a moot point for most of us, because access to most good hedge funds has too high of a price tag anyway. If you don’t have $10 Million to invest in a hedge fund, it really doesn’t matter what there structure is.

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

With managed futures, you get affordability and the protection of individually managed accounts. That protection means you don’t have to worry about the fraud risk, redemption risk, and transparency risk associated with funds. With managed futures, the manager doesn’t have access to your funds, other investors’ redemptions don’t affect individual accounts, and you can see all the trades put on for your account.

Bad things can still happen in an individually managed account, of course. A manager can start putting on trades he or she shouldn’t be, doubling up to make up, and so on. But those are risks we can quantify and identify as the investment progresses. One goal of due diligence is to identify all of the non-investment related risks, so that you can separate those from the trading related risks. It is one thing to lose money because a manager traded a market poorly and suffered poor performance, but quite another to lose money because a manager was a fraud, didn’t have sufficient operations to handle the money, and so on. The main difference is we can avoid second type of risk by indentifying it beforehand.

In the end, the main lesson (as always) should be to diversify! There are people who had their entire net worth with Madoff that are now out hundreds of millions of dollars. This is just not smart, plain and simple. If your goal is to protect as well as grow assets, diversifying is a must. This may appear to increase your risk in terms of volatility or max drawdown, but it decreases the main risk we should all be worried about – the risk of ruin. No matter how well something has performed, no matter how many “smart people” are invested in it, if you have all your eggs in one basket – your risk of ruin is greatest.

- Walter Gallwas

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Energies, stocks, grains all rally on hopes of yet another bailout

Overview

A week of relief greeted most commodity and index futures markets as anxiety about a recession ebbed for the time being. Headlines of a possible steep production cut by OPEC at their upcoming meeting and a possible government resolution to the automaker crisis seemed to bring stability to the marketplace.  Once again energies were the leader, as RBOB Gas gained +16.48%, Crude Oil added +11.92% and Heating Oil was up +4.56%. Natural Gas shed -4.53% on higher production and storage figures seen on the weekly reports. 

The Metals sector also posted strong gains during the past week as hard asset buying by investors was the main factor along with various reports that mining production by some major companies would be reduced for the time being.  For the week Silver +8.93% led the way followed by Gold +8.43%, Palladium +8.13%, Platinum +4.35% and Copper +3.96%.     

Commodity and food sectors also saw moves higher as support came from production worries in the Southern Hemisphere along with ideas that the recent sharp sell off could uncover demand at current price levels. The grains were led higher by Corn +17.26%, Soybeans gained +8.17% and Wheat added +7.51%. The soft sector was led higher by Cocoa +10.75% followed by Sugar +9.29%, Coffee +7.99%, Cotton +4.83% and OJ +2.19%. In the livestock sector Live Cattle ended the week +1.74% and Lean Hogs fell -3.11%.      

Stock Index futures continued to experience active volatility on both sides of unchanged, but signs that the U.S. government in some form or fashion would come to the rescue of the troubled automaker sector led to some optimism and weekly gains. The one thing that stood out as the week progressed was how the market seemed to brush aside weak economic releases which could indicate that most of the bad news might be factored in to the current price structure. The small cap sector fared the best with Mid Cap futures up +3.98% and the Russell futures ended +3.45% higher. The large caps were led by the NASDAQ futures +2.89, with the S&P 500 futures +1.67% and Dow futures +0.91%.         

Currency futures were fairly active as the U.S. Dollar Index lost -4.48% on ideas the U.S. Fed would lower lending rates at their upcoming meeting which sent investor into the continentals looking for better yields. For the week the Euro gained +4.86%, Swiss Franc was up +3.52%, British Pound added +1.98% and the Japanese Yen was +1.77% higher. 30-year Bond futures ended up +.95%, and 10-year Notes futures gained +.99% as support continued to stem from flight to quality buying. 

Managed Futures

After starting the month on a strong note, Systematic Multi-Market mangers have diverted somewhat lately as we’ve seen a mixed range of returns so far in December. With many of the trends in the stock indices, bonds, and energy markets appearing to have reached a possible turning point after months of one directional movement, mangers with longer term positions have seen losses while shorter term multi-market managers remain ahead for the month.

Heading into the day today, the top December performer is Attain Portfolio Advisors Modified Program which is ahead approximately +3.6%.  Modified is designed to capitalize on trends across 3 different time frames (long-term, intermediate-term, and short-term); hence it has not been as heavily affected by the reversing trends.  Ironically, the APA Strategic Diversification Program is down nearly -1% for the month, with the difference being the main program’s exposure to several higher risk trades the Modified program has not participated in.

Other Multi-Market manger estimates are as follows: Clarke Global Basic -1.88%, Clarke Global Magnum -0.88%, Claughton Capital -3.76%, Hoffman Asset +0.26%, Robinson Langley +0.26%.

Multi-Market Discretionary manager estimates are as follows: Dighton Capital -6.29%, Lone Wolf Investments +1.09%, and MSLO -0.55%.

As for Option Trading mangers, in this section we have been discussing the potential for a looming recovery by short volatility mangers; based on this months current estimates this theory continues to be an evolving story.  Current Option Trading estimates are as follows: Ace Investments +4.20%, Cervino Diversified Options +0.22%, Cervino Diversified 2x +0.52%, Crescent Bay PSI +0.05%, Crescent Bay BVP +0.54%, FCI +0.3%, Rathiel Investments +0.17%, and Zenith Index remained out of the market.

Finally, Agriculture and Grain CTAs have continued to have difficulty finding a positive direction through the current environment.  Current estimates are as follows: NDX Abednego -0.55%, NDX Shadrach +1.39%, and Rosetta -2.5%.

Systems

Trading conditions were choppy last week as all eyes were fixed on the U.S. automaker bailout coupled with the FOMC meeting this Tuesday. There were still some opportunities for trading systems, particularly those that were more selective in their entries.

Beginning with the swing programs, Strategic ES had a strong showing of +$3,757.50 for the week on a closed trade basis. Not too far behind was sister system AG Mechwarrior ES +$2,515 on a pair of trades, both long entries. Mesa Notes TY reversed long early in the week for a loss of -$397 but picked up some open trade equity on the new long trade that it held heading into the weekend. Finally, Ultramini ES had one trade for -$410.

Moving on to the day trading programs, trading activity was fairly quiet as the market seesawed from positive to negative on several occasions throughout the week. Waugh eRL was able to capitalize on some late moves in the Emini Russell 2000 gaining +$2,335 on four trades. Compass SP had two short trades that netted +$200 for the week. Lastly, Rayo Plus Dax had a tumultuous week, losing  -$11,625 on five trades.

In long-term trading, commodity markets rebounded virtually across the board with large gains in Crude Oil, RBOB Gasoline, Corn, Gold and Silver. The aforementioned rally triggered some short exits in metals but also gave bears the opportunity to increase their short positions at favorable levels. The U.S. Dollar also sold off sharply for the week triggering some long exits after the recent run-up over the past few months.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.