Fraudsters like Bernie Madoff are keen to capitalize on our complacencies. Ron Surz is president of PPCA, a San Clemente, Calif.-based software firm that provides performance-evaluation and attribution analytics, a principal of RCG Capital Partners, a Denver, Colo.-based fund-of-hedge-funds manager, and a co-founder of target-date index maker Target Date Analytics.

For weeks now the media have been trotting out experts -- financial intermediaries, for the most part -- to advise people on avoiding the likes of Bernard Madoff. That's like asking gun manufacturers to weigh in on ways to lower homicide rates. Predictably, the real issue --lax due diligence -- has been lost to such sterling insights as be suspicious of good performance and insist on financial audits.

Beside the point

Skepticism about performance is the province of financial intermediaries, not investors. Investors rely on their consultants and fund-of-fund managers to scrutinize performance for potential fraud. Similarly, financial audits are not designed to validate reported performance; audits verify procedures and pricing.

The best defense against fraud is a strong offense in the form of real due diligence rather than the sham that has been played upon investors by their advisors. Hedge-fund due diligence has, by and large, been a big fat fakeout. The gun in Madoff's hands was advisor complacency; the fallout from Madoff should be greater scrutiny of advisors by their clients.

Remarks by Yale endowment manager David Swensen in a recent interview with the Wall Street Journal set alarms off throughout the investment community.

WSJ: What about fund of funds and consultants? Can they be a solution?

Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There're also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as [many] resources were it not for fund of funds.

Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.

Shamless

Swensen goes too far when he suggests malicious intent by consultants and fund-of-funds. Cancers never intend anything either way. Besides, as someone once said, "Never attribute to malice what can adequately be explained by stupidity."

Due diligence can be boiled down to two crucial questions: Do we like the strategy that this manager employs? Does this manager execute the strategy well?

Common hedge fund due diligence, as it is practiced today, answers the first question with hot performance, and accepts conceit and concealment as answers to the second.

In other words, investors have been shammed by fake due diligence. The Madoff scam was enabled by this due diligence sham.

Now I'm going to describe a due-diligence approach that is rigorous and sham free.

The adage "Don't invest in what you don't understand" is particularly relevant to hedge-fund investing. To address this issue we recommend that the researcher complete a fairly straightforward profile like this: Approach long: exposures to styles, sectors, countries, etc., as well as exposures to economic factors. Approach short: exposures to styles, sectors, countries, etc., as well as exposures to economic factors. Direction: amounts long and short Leverage Portfolio construction approach: number of names, constraints, derivatives, etc.

If we can complete this profile we can move on to the question of manager competence. The profile gives us the option of replicating or hiring (make or buy), so we want to know that value added exceeds fees.

The traditional approaches to this assessment are peer group and index comparisons, but these are unreliable backdrops for evaluating hedge-fund performance. Anyone who has earned the CFA designation has learned the problems with peer groups: they're loaded with biases. But biases are not the major problem with hedge fund peer groups. The fact that hedge funds are unique is the big problem. Harry Kat of the Cass Business School in London has documented a lack of correlation among funds in the same peer group. It is virtually impossible to construct an appropriate peer group for a specific hedge-fund manager. And since hedge-fund indexes are constructed from these faulty peer groups they are also unreliable. We need a better skill assessment approach.

Fool me once

Albert Einstein said, "The problems we face today cannot be solved at the same level of thinking that created them." A corollary is that it's unlikely that the people who created the problems can succeed at fixing them.

The solution to the problems with peer groups and indexes is actually quite simple, at least in concept. Performance evaluation ought to be viewed as a hypothesis test where the validity of the hypothesis "Performance is good" is assessed. To accept or reject this hypothesis, construct all of the possible outcomes and see where the actual performance result falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not good. In other words, the hypothesis test compares what actually happened to what could have happened.

Using the profile described above, a computer simulation randomly generates portfolios that comprise a custom scientific peer group for evaluating investment performance. A reported return outside the realm of possibilities is suspicious, and can be explained in one of three ways: the return is in fact extraordinary, the return is fraudulent, or the strategy has not been followed. Of course the test itself cannot tell us which of the three possibilities the reality is, but it at least gives us motive to look. In other words, the hypothesis test either validates the credibility of reported performance or provides the wherewithal to question the incredible. Financial audits are not designed to provide this validation.

Sociopathic fraudsters like Madoff are keen to capitalize on our complacencies. But there is a defense. Hypothesis testing sets off fraud alerts that cannot be achieved with antiquated due diligence approaches, and this testing also puts an end to the due diligence sham.

Madoff was no garden variety bandit. Few appeared to be more trustworthy. So some say that the important lesson from this mess is that no amount of due diligence can protect us from violations of trust. I disagree, and advocate a "trust but verify" approach rather than resolving to be tricked by the next Madoff.

Fool me once, shame on you; fool me twice, shame on me. -FWR

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