Madoff: The Affect On Private Investors/ Market Sentiment

The direct effects are limited, but indirect effects could be large. In speaking with hedge fund investors and advisors over the past week, Madoff's investors appear to be overwhelmingly high net worth individuals in Europe and the U.S.

The destruction of wealth from those high net worth individuals will have a devastating effect on private banks, and certain crowds in London, Paris, Geneva, Manhattan and Palm Beach.

But institutional investors, and most hedge fund investors of modest means (a million to say, $5 million or so) appear to have much less exposure.

It seems that most pensions, endowments, and foundations (with the exception of certain Jewish charities), have very little invested with Madoff. One hedge fund advisor I spoke with told me that of 75 institutional funds he spoke with, only 6 had exposure with Madoff, with average exposure of those who had money with him a little over 2 percent.

It's the indirect effects that worry the hedge fund industry. Every single hedge fund investor I have spoken to in the past week feels that there will be additional redemption requests in the first quarter as a result of small investors losing confidence in hedge funds.

But should those people be in hedge funds to begin with? Those people who have, say a few million in hedge funds, arguably should not be in hedge funds because it is very difficult for them to invest without getting ripped off.

Indeed, the very idea that individuals get a better return with hedge funds is probably flat-out wrong. In the past ten years, compare the MSCI Global Index, the Hedge Fund Research Index, and government bonds.

The best returning investment appears to have been government bonds.

Self-administered funds are in big trouble. There's no doubt self-administered funds will have a tougher time getting money. Indeed, one of the biggest problems with Madoff was the apparent lack of independence in the back office--in accounting, administration, and record keeping. No one will invest in firms that are self-administered in the future. The good news is that probably less than 15 percent of U.S.-based funds were self-administered.

The hedge fund industry will be shrinking. How much is uncertain, but it seems likely that there is already a 40 percent shrinkage in assets under management. Here's why: hedge funds as a group are down about 17 percent this year, just assuming another 20 percent in redemptions and you're already at a 40 percent drop.

Assuming $2 trillion under management, and you could easily go down to $1.2 trillion if you haven't already. Yes, putting up gates will slow down redemptions, but no one believes it will stop it.

After redemptions in the first quarter of 2009, it's likely we could go under a trillion in assets under management.

Is this bad news? It means less invested in markets, but it may mean a lot less volatility as well. Having less money in hedge funds is good long term because it means less competition for investment ideas.

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- The Dow 30 at a Glance

Questions? Comments?