THE BLOG
01/19/2009 05:12 am ET Updated May 25, 2011

Hedge Funds as Victims?

The Madoff (alleged) mega-scam is ruining lives worldwide. The tales of loss seem too widespread to be caused by one man. Yet, we know from history that it takes only one depraved or greedy sociopath to destroy millions. The individuals, widows and pensioners who lost their money deserve tremendous sympathy. But the hedge funds and other "sophisticated investors" who invested with Madoff should reserve a little blame for themselves.

Blame the victim? In the case of the hedge funds, yes.

Hedge fund are required to carefully investigate their potential investments. When a "fund-of-funds" farms its money out to another manager, a few simple questions are due diligence 101. The first question for any hedge fund parking its money with an outside manager should be: Is this manager's money held by a separate, independent custodian? In Madoff's case the answer was apparently "no" and the hedge fund should have run--not walked--the other way. Reportedly, Madoff owned and operated his own brokerage firm to hold client assets. This is questionable and unusual. It's not just a red flag but a neon billboard.

I run an SEC registered investment advisory firm. We operate an investment fund and separate accounts. All of our client brokerage assets are held securely at Charles Schwab & Company, an independent custodian. Any improper activity or disbursements from individual accounts could easily be spotted by both the client and the custodian. This division between management and custodian provides great security and constitutes the industry standard. When custody and management are appropriately split, it would be extremely difficult--if not impossible--to run a Ponzi scheme.

Maybe it's time to prevent funds-of-funds from giving money to managers who hold custody. Or perhaps we should change the law to prevent managers from having custody of client assets. Either way, the hedge funds that went with Madoff--knowing the man entrusted to manage the money was also apparently holding it--didn't ask the right question. Or didn't listen to the answer.