Archive for December, 2008

How Bernie Madoff With the Money

Kurt Brouwer December 29th, 2008

My apologies for the play on words in the title.  Just could not help myself.

By all accounts, the Madoff scandal was a fraud of epic proportions and a betrayal of those who entrusted their assets to him. If you have somehow missed out on the details of this $50 billion fraud, see Wall Street Journal — Madoff.

My reason for posting on this is quite simple.  I have noticed a lack of clarity as to why — or more importantly — how it could have happened.

From what I have read, this investment fraud was made possible chiefly because investors with Madoff did not have an independent custodian for the assets entrusted to his firm.  If there had been an independent custodian, I think the scheme would never have been possible.  For example, it appears that Madoff did not make the trades in clients accounts that he claimed to have made.  If those clients had an independent custodian, they would have seen their account holdings and transactions on the statement.  If Madoff claimed to have made a given trade, but it never hit the client’s acount, a serious red flag would have been raised.  Also, the returns he claimed were exaggerated.  If clients were receiving accurate statements from the custodian, they would have known his performance claims were false.

Yes, investors could have dug deeper and questioned him further, but, in my opinion, the scheme was possible only because the Madoff firm was a brokerage firm that created its own client statements.  In short, there was no independent verification that those reports were accurate.  The Madoff scheme illustrates what can happen if you lack one of the very important checks and balances that are part of a sound investment structure.

Like many registered investment advisory firms, our firm, Brouwer & Janachowski, LLC, does not hold clients assets directly.  Instead, clients have their assets in an account at an independent custodian that provides clients with statements showing the value of their assets, the number of positions held and so on.  This type of independent verification of your account status is critical.  We direct the investments in those accounts, but the positions held as well as the value of those investments are clearly shown in the statements from the custodian.

A second layer of protection exists for those who, like us, invest primarily in mutual funds because independent reporting on fund results is built by law into the mutual fund structure.

This piece from Brett Arends’ excellent ROI column in the Wall Street Journal makes the point that mutual funds are looking pretty good these days compared to the disaster experienced by the seemingly-sophisticated investors in the Madoff scheme. He lists 10 points from which I excerpted those I thought were most critical [emphasis added]:

Madoff: a Walking Ad for Mutual Funds (Wall Street Journal, December 16, 2020, Brett Arends)

A multibillion-dollar Ponzi scheme reinforces classic investment advice: If it sounds too good to be true, it probably is.

Bernard Madoff has done the impossible: He’s made the rest of Wall Street look good this year.

OK, so your funds lost 40% or more. Mr. Madoff’s clients, from charities to the super-rich, lost the whole salami.

Call it another reason to steer clear of so-called financial wizards and miracle investment funds. Here are 10 reasons why you’re better off opening an online account and investing in ordinary mutual funds - like anyone else.

1. You’ll always know where your money is, and you can get it out at any time…

2. You always know how you’re doing, too. Performance figures are updated daily…

4. Everything is out in the open. Mutual funds have to publish regular updates, telling you what they’ve been doing and why. Mr. Madoff actually kicked people out his fund if they asked too many questions…

Lucky people.  Can you imagine how relieved you would be to have been one of those folks Madoff kicked out?

7. You can still get all the diversification you want. Though regular mutual funds you can invest in hedge-fund like “market neutral’ funds, managed timber, Asian real estate, precious metals, and option-selling income funds. You can keep your money in inflation-protected government bonds or Japanese yen. Exactly how much more diversification did you really need?

This is an important point that is often overlooked.  Mutual funds cover a very broad array of investment opportunities, from stocks and bonds to gold, energy and many other asset classes.

9. And when you keep your money in public funds you won’t wake up one morning, switch on the news, and discover it’s all gone. The worst one-day loss in history for investors who entrusted their money to the U.S. public markets is about 20%. It happened just once, October 19, 2020 - and they got their money back in due course.

10. And if you really need to brag about your money at the country club, an $8 online trade and a $3,300 stake can get you one share in Berkshire Hathaway. Then you can smugly say, “I have my money with Warren Buffett.” Do you really believe your brother in law’s “financial whiz” is any better?

If you want to share in Buffett’s professional work, you can buy stock in his company, Berkshire Hathaway, which has some similarities to a closed-end mutual fund.  Or, you can buy shares in mutual funds that own sizeable stakes in Berkshire Hathaway.  The best-known of these funds is Sequoia Fund, which recently re-opened to investors (see Sequoia Fund To Open Up Again).

Obviously, most mutual funds have taken a hit this year.  However, they have avoided scandals like the Madoff mess because of the checks and balances inherent to the mutual fund structure itself.  This chart and text give you a sense of how funds work.  It is excerpted from the Investment Company Factbook, which is created each year by the Investment Company Institute:

Source: Investment Company Institute

As you can see, mutual funds have an explicit structure with checks and balances including an independent audit by a public accounting firm.  Investors in mutual funds typically focus on the fund’s portfolio manager and the types of returns the fund has gotten.  It is only in times such as these that other aspects of the mutual fund structure come into focus.  Those are illustrated in the chart above and in this text from the Factbook about the relatively unsung roles of the custodian and the transfer agent:


Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Nearly all mutual funds use banks as their custodians. The SEC requires any bank acting as a mutual fund custodian to comply with various regulatory requirements designed to protect the fund’s assets, including provisions requiring the bank to segregate mutual fund portfolio securities from other bank assets.

Transfer Agents

Mutual funds and their shareholders also rely on the services of transfer agents to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments, including call centers, to respond to shareholder inquiries.

Here are several points I have made over the years.  They illustrate precisely why mutual funds are so unique in the wild and woolly world of investing.

Mutual Funds Are A Unique Investment Vehicle

Mutual funds offer a package of advantages available nowhere else:

• Low minimum investment

• Immediate diversification

• Professional management

• Security

• Liquidity

• Audited track records

The first modern mutual fund was the Massachusetts Investors Trust, which came along in 1924, but it took years of trial and error, and a lot of misery before the mutual fund industry, as a whole, adopted the structure and safeguards we take for granted today.The shocking stock market crash of 1929 sparked the Great Depression of the 1930s-10 years of poverty, disillusionment and despair for many. Yet out of that disastrous decade came many reforms (such as the Securities Act of 1933, the Glass-Steagal Act of 1933 and the Fair Labor Standards Act) and the creation of many governmental oversight agencies (the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission, the National Labor Relations Board (NRLB), and the Federal Communications Commission, to name a few). For mutual fund investors, the watershed event was the passage by Congress of The Investment Company Act of 1940, which created the mutual fund structure as we know it today.

Mutual Funds & The Integrated Circuit?

By way of comparison, let’s travel back in time to California in 1959. In case you’ve forgotten, that was when Jack Kilby and Robert Noyce created the first integrated circuit, a single chip of silicon that replaced thousands of transistors and other electrical components and ushered in an era of unprecedented innovation as computer technology became cheaper and more powerful, year after year. From being the exclusive province of governments and well-funded university research laboratories, computer technology is now so pervasive and so inexpensive that we cannot imagine a world without it.

Just as the integrated circuit (the forebear to what we now call the semiconductor) brought computing power to people everywhere, the creation of the modern mutual fund structure changed the nature of financial services and opened up sophisticated investments to investors of all types. One piece of legislation created a new era for investors by setting up the safeguards and structure that enabled mutual funds to become the dominant investment vehicle they are today. This was a relatively simple innovation that did not receive much notice at the time. Yet, it opened up a myriad of possibilities and brought professional management, diversification, safety and other tangible benefits into the hands of all investors, no matter how much money or how little money they have.

Today, there are more mutual funds than stocks on the New York Stock Exchange. New funds open daily, offering a dazzling and sometimes intimidating array of choices. The competition for your money is so intense, that new innovations, marketing approaches, investment styles and services are being announced daily. The smartest people on Wall Street are eager and willing to work for you, for a nominal annual fee. In all of human history, there has never been a time like this.

The ’40 Investment Company Act — History’s Most Effective Regulation

So, we can thank the far-sighted legislators who created the modern mutual fund more than 60 years ago when they passed the Investment Company Act of 1940.  That legislation has given us a golden era for investors that was previously unavailable to all but the very rich.  And, as we have seen with the Madoff mess, even the rich would have been better off using mutual funds.  Those who did avoided all these problems (Hedge Fund Troubles Take Tragic Turn).

But, even if you do not invest in mutual funds, there is an important safety feature that mutual funds pioneered — the independent custodian.  If you invest in investment partnerships, hedge funds and other private investments, you can avoid the heartbreak now being felt by those who invested with Madoff  — just make sure there is an independent custodian that holds your assets and reports to you as to the value of those assets.

If you take that simple step, you won’t ever have to wonder if someone is about to make off with your money.

Via: Rita Lee

A Mountain of Cash

Kurt Brouwer December 29th, 2008

There is a mountain of cash in money market funds, Treasury Bills, certificates of deposit and other holding places.  In fact, there is nearly $9 trillion in cash on the sidelines as this Bloomberg piece points out [emphasis added]:

Cash At 18-Year High Makes Stocks a Buy at Leuthold (Bloomberg, December 29, 2020,  Eric Martin and Michael Tsang)

There’s more cash available to buy shares than at any time in almost two decades, a sign to some of the most successful investors that equities will rebound after the worst year for U.S. stocks since the Great Depression.

The $8.85 trillion held in cash, bank deposits and money- market funds is equal to 74 percent of the market value of U.S. companies, the highest ratio since 1990, according to Federal Reserve data compiled by Leuthold Group and Bloomberg.

Leuthold, Invesco Aim Advisors Inc., Hennessy Advisors Inc. and BlackRock Inc., which together oversee almost $1.7 trillion, say that’s a sign the Standard & Poor’s 500 Index will rise after $1 trillion in credit losses sent the benchmark index for American equities to the biggest annual drop since 1931. The eight previous times that cash peaked compared with the market’s capitalization the S&P 500 rose an average 24 percent in six months, data compiled by Bloomberg show.

“There is a store of cash out there that is able to take the market higher,” said Eric Bjorgen, who helps oversee $3.4 billion at Leuthold in Minneapolis. “The same dollar you had last year buys you twice as much S&P 500 as it did a year ago.”

… “What the cash pile on the sidelines represents is dry powder,” said Fritz Meyer, the Denver-based senior market strategist at Invesco Aim, which manages about $358 billion.

…This year’s slump has left S&P 500 companies valued at an average of 12.6 times operating profit, the cheapest since at least 1998, monthly data compiled by Bloomberg show.

…Cash holdings peaked one month before equities began to recover during the two longest recessions since World War II. In July 1982, money of zero maturity as a percentage of the U.S. stock market’s value rose to 95 percent before a 20-month bear market ended and the S&P 500 began a six-month, 36 percent advance, data compiled by Bloomberg show.

Cash on hand reached $604.5 billion in September 1974, representing a record 1.21 times U.S. stock capitalization. That preceded a 31 percent gain in equities between October 1974 and March 1975, Bloomberg data show.

…The last time cash accounted for a larger proportion of market value was 1990. The ratio peaked at 75 percent in October of that year, after the savings and loan industry collapsed, Drexel Burnham Lambert Inc. was forced into bankruptcy and the U.S. fell into a recession. The S&P 500 rallied 23 percent in six months and almost 30 percent in a year…

I remember all the rallies mentioned in this piece and I can safely state that there were few signs of an impending rally in stocks during those periods.  In all cases, the economy was still very weak and the news was uniformly gloomy.

I don’t know when this stock market will rally, but it will do so.  The enormous quantity of cash on the sidelines will not all go into stocks, but some of it will once the rally begins.

Winston Churchill — Private Enterprise

Kurt Brouwer December 29th, 2008

I am a big fan of Winston Churchill.  Here is a quotation from a speech he made in 1959 on the topic of private enterprise:

Some…regard private enterprise as a predatory tiger to be shot.  Others look on it as a cow they can milk.

Only a handful see it for what it really is - the strong and willing horse that pulls the whole cart along.

This is from Churchill’s last political speech, given on September 29, 2020.  As quoted in:

Churchill by Himself by Richard Langworth (Public Affairs, 2008)

Saving Money at the Pump

Hedge Fund Troubles Take Tragic Turn

Kurt Brouwer December 24th, 2008

Large pension plans, charities and wealthy investors moved many billions of dollars into hedge funds over the past few years. I don’t expect that move to stop completely because alternative investments such as hedge funds can add value if they are carefully selected. However, this movement became somewhat fad-like and, like so many fads, it is ending in tears.

For years, investors in hedge funds and enjoyed healthy returns.  But now, things have changed.  Over the past year, investors have seen the dark side of hedge fund investing as performance faltered and hedge funds closed. Now, we are beginning to see the human toll from hedge fund woes. The following are all the hedge fund-related headlines from yesterday’s Bloomberg’s home page [emphasis added below]:

Madoff Fund Operator Who Had $1.4 Billion Invested Found Dead in New York

Thierry Magon de La Villehuchet, who ran a fund that invested with Bernard Madoff, was found dead today in his New York office in an apparent suicide, Police Commissioner Raymond Kelly said. “Our investigative premise is that it was a suicide,” Kelly said in an interview…

Cerberus Limits Client Withdrawals From Hedge Fund for One Year After Loss

Cerberus Capital Management LLC, the $26 billion investment firm founded by billionaire Stephen Feinberg, limited investor withdrawals from one of its hedge funds after it lost 16 percent this year through November.

The restrictions, known as gates, were triggered after clients sought to pull more than 16.5 percent of their money from Cerberus Partners LP by the end of the year, according to a Dec. 19 letter sent to clients. The limits on redemptions will last for one year.

Billionaire Feinberg Despised in Wisconsin Where Cerberus Lives Up to Name

Just about everyone in Kimberly, Wisconsin, hates billionaire Stephen Feinberg.

“This is a greedy, extremely greedy guy who doesn’t care about other human beings,” said Jeffery Wyngard, a third- generation Kimberly mill worker with 30 years on the job.

“Feinberg has no morals,” said paper mill workers union local president Andy Nirschl.

“There won’t be a lot of Stephen Feinberg Little League fields,” said Bob Brukardt, who also worked at the mill for 30 years. “He sold his soul to the devil.”

Feinberg inspires this reaction in Kimberly because Cerberus Capital Management LLC, the company he founded in 1992, owns NewPage Corp., which closed the town’s 119-year-old paper mill that Local 2-9 of the United Steelworkers says was profitable when NewPage bought it nine months ago. Six hundred people are out of work in the town of 6,200 at the same time Cerberus’s money-losing Chrysler LLC automotive unit was seeking a taxpayer loan…

Tontine Capital to Start New Hedge Fund After Losses Topped 60% This Year

Jeffrey Gendell, whose investment firm Tontine Associates LLC is liquidating two hedge funds after losses of more than 60 percent this year, plans to start a new fund in February.

The Tontine Total Return Fund will invest in stocks believed to be undervalued and won’t use borrowed money, Gendell said in a letter to investors. Steve Bruce, a spokesman for Greenwich, Connecticut-based Tontine, declined to comment.

Tontine, started by Gendell 12 years ago, had been one of the industry’s best performers, with its four funds returning an average of 38 percent annually since inception through 2007. The firm last month said it was unwinding Tontine Capital Partners LP, a fund that plunged 77 percent this year through October, and Tontine Partners LP, which fell 67 percent through September.

“I would be very surprised if people allocated new capital with him after such losses,” said Graziano Lusenti, founder of Nyon, Switzerland-based Lusenti Partners LLC, an investment adviser.

Gendell isn’t the first to seek investments for new funds after losing money for clients. Nicholas Maounis, whose hedge- fund firm Amaranth Advisors LLC collapsed under a record $6.6 billion loss in 2006, started a new fund in October.

Buyout, Hedge Funds Must Reorganize to Avoid Tax Increases, Lawyers Say

Tax lawyers are urging private- equity and hedge-fund clients to restructure their partnerships so they can sidestep the higher taxes that President-elect Barack Obama has vowed to impose on their profits…

Hedge Fund Investing

The term hedge fund is a bit confusing to many people because many ‘hedge’ funds take lots of risk and do not seem to balance out the risks they are taking. Yet, the term hedge itself implies the principle of hedging your bet, which means reducing the risk you take.

The original hedge fund was started almost 60 years ago by an innovative man named A.W. Jones.  Today, Jones’ original fund would be known as a long/short fund.  That is, it bought stocks the manager thought were undervalued, but also balanced or ‘hedged’ that exposure by shorting stocks he did not like. Jones also used leverage or borrowing to accelerate returns. Jones also pioneered the use of incentive fees.

The term hedge fund is primarily a reference to an investment partnership of some type in which the general partner or managing member charges a management fee and an incentive fee or carried interest. This is often 2% as a management fee and 20% as an incentive fee.

Because hedge funds have so much investment flexibility, investors need to be convinced that the portfolio manager has an excellent strategy and also that the manager cares deeply about the interests of investors. Many hedge funds have a structure that prevents the management team from earning incentive fees until the hedge fund gets back to its ‘high water’ mark.  That is, until it gets back all the losses it has incurred.  But, if the high water mark is distant, there may be an incentive for the management team to close the fund and start a new one without a distant high water mark.

There is nothing wrong with hedge funds as an investment structure. However, the details are critical. They have to be carefully-selected both as individual investments and as to their impact on an overall portfolio. In short, they have to make investment sense. Another issue to be examined is risk.  Does the hedge fund use leverage or borrowed money to enhance its returns?  If so, that adds significantly to potential risk.  The other issue is cost structure in that their cost structure has to be reasonable for what they do. No doubt there are investment strategies that can warrant the 2 and 20 cost structure, but that is a high hurdle to overcome.

As these headlines indicate, many investors who jumped on the hedge fund bandwagon have now concluded that it is time to jump off.  See also Hedge Fund Withdrawals Roil Markets and Many Hedge Funds Closing.

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