The Financial Services Industry's Free Lunch

The lesson of the US$50 billion Ponzi scheme perpetrated by fraudulent investment guru Bernard L. Madoff is not just the danger of trusting people who belong to the same club or ethnic group, nor even of the importance of making simple checks on the bona fides of an investment intermediary.

Madoff represents the tip of a much bigger – though not actually fraudulent – scandal, the percentage of an individual’s savings lopped off by the multi-tiered structure of much of the financial services industry. One casualty of recent events should be the profits of intermediaries and there are plenty of indications – such as from Hong Kong-listed fund manager Value Partners – that this is beginning to happen. However, an even bigger question market hangs over the bona fides of some of the institutions that passed funds to managers, be they honest ones like Value Partners or dishonest ones such as Madoff.

Madoff appears to have collected larger sums to manage from other investment institutions, including banks and pension funds with their own investment arms, than he did from the gullible rich individuals and Jewish-related charities that put their trust in his name. Likewise, most of the assets under management of Value Partners are not from retail individuals or even rich private clients. At last count, 80 percent were from other financial institutions, pension funds, funds of funds, and foundations.

It is all a reminder of the original “fund of funds” concept, which enabled the collection of multiple fees through a fund pyramid, originated by the notorious Bernie Cornfeld of Investors Overseas Services back in the 1960s. But even Cornfeld never dreamed up a heads-I-win tails-you-lose scheme like the 15 percent of asset value increases taken by those fund managers – including Value Partners – who have been able to tout the notion of their superior skills to gullible investors.

In the Madoff case, according to the New York Times, one so-called feeder fund, Fairfield Sentry, collected $250 million in 2007 alone from Madoff funds, whether by way of commission or (bogus) performance fees. But this seems to have been just the tip of a fund of funds scam common throughout the financial services industry. According to a Bloomberg report, some individual bankers at Credit Swiss were unhappy that the bank advised against investing in Madoff because of its lack of transparency. The reason seems to be that commissions provided a tidy little cash flow called “retrocessions” – a polite bankerly word for kickbacks.

Said the Bloomberg report: “These retrocessions are an open secret in the private banking world, and in most cases they aren’t passed on to clients,’ said Bernhard Bauhofer, founder of Wollerau, Switzerland-based consulting firm Sparring Partners GmbH. “’The Swiss private banks depend a lot on these.”

For sure, there are many legitimate cases in which an institution would devolve part of its fund management to another. No one is an expert on every market and instrument. For instance there are many institutions in the US which would like some exposure to China or other parts of Asia but have no capacity to judge either the markets or their stocks. So they prefer to pass on choice of investment in China to those closer to the companies and markets.

But that certainly is not entirely the case with all Value Partners’ institutional clients, many of whom are in Hong Kong. Fee arrangements would doubtless be less than the 5 percent up-front that retail investors mostly pay, and perhaps less than the 1.5 percent of assets annual management fee. But the institutions which pass on the work will have already collected their own management fees. So at best there is likely to be a layering of fees which keeps the institutions in business but erode returns to investors.


But management fees are a minor issue compared with the bizarre arrangements under which institutions not only delegate to other managers but allow the latter 15 percent of asset price gains but make no allowance for repayments if markets go down. The performance fees in most cases are based on total return, not performance relative to peer benchmarks.

Either those who commit their clients’ funds to many such arrangements must either be very stupid or have ulterior motives – motives closer to “retrocessions” than to the interests of their clients.

There are of course funds with complex hedging schemes or that cover seriously obscure areas of the market which probably need such incentives for anyone to bother to create them. But in the case of many such funds, almost all their assets are in absolute return, long-term, long-only investments. These are just the kind of plain vanilla investments which in the long run are unlikely to do very much better or worse than their peer group – as indeed has been the case with Value Partners over the past four years.

Just how costly these arrangements can be to investors is demonstrated by the fact that in 2007 Value Partners earned HK$2.075 billion in performance fees, compared with just HK$436 million in management fees on assets at year end of HK$56 billion All told fees represented about 4.5 percent of funds under management. For 2008, performance fees will vanish and Value Partners has had to issue a dire profit warning. But it can live comfortably on management fees alone, and meanwhile investors who now seen their funds down 40 percent or whatever will be not be able to claim back any of that HK$2 billion the company collected for simply riding a market wave which has now broken.

That is not the fault of Value Partners but of those institutional investors dumb or lazy enough to accept such fee arrangements -- which a good lawyer could argue represented a breach of trust towards their clients who had paid them professional fees.

The 15 percent performance fee had become all too common in New York and London, the centers of the hedge fund and private equity business. Now the world has turned upside down and many hedge funds which took hefty fees when markets went up have now closed their doors to redemptions.

Value Partners, with no gearing and investments mostly in liquid stocks, is in no such predicament. Nonetheless it may be suffering permanent losses as institutions wise up to the peril of agreeing to performance fees – or at least ones not geared to a peer benchmark. By end-November Value Partners funds under management had fallen to US$3.0 billion from US$7.3 billion at end 2007. That fall has been significantly bigger than the decline in net assets per share of its funds.

There appears to be a huge area of questionable and unregulated practices throughout the financial world of commissions received and paid which are not reported to clients. These went unnoticed when asset prices were rising but are now exposed for what they are.

Fund managers and feeder institutions are by no means alone in this. Other aspects of this have been seen with the behavior of retail banks which found they could make more money from commissions on selling the products of other institutions than by offering them regular banking services or plain vanilla equity investments.

That explains how supposedly blue-chip banks came to sell dross such as Lehman mini-bonds to unsuspecting retail investors in Hong Kong, Singapore and elsewhere. It even explains how the Hong Kong government came to devise a Mandatory Provident Fund scheme which hands massive profits to a few chosen intermediaries for doing very little.

The silver lining of this market collapse is that hopefully it will fumigate savings systems and kill off at least some of the leech-like practices which have enriched a few at the expense of the many.