There have been a number of scandals involving hedge funds over the years. A few of these scandals include the Bernie Madoff investment scandal and the Galleon Group and SAC Capital insider trading scandals. Despite these hedge fund scandals rocking the investment community, the number of assets under management in hedge funds continues to grow.

Hedge funds use pooled funds from large institutional investors or high-net-worth individuals (HNWIs) to employ various strategies that seek to create alpha for their investors. Many hedge funds have lower correlations to stock indexes and other common investments. This makes hedge funds a good way to diversify a portfolio. Most hedge funds are well run and do not engage in unethical or illegal behavior. However, with intense competition and large amounts of capital at stake, there are less than scrupulous hedge funds out there.

Key Takeaways

  • Hedge funds have been attractive to ultra high-net-worth individuals and organizations seeking to boost returns with esoteric and complex trading strategies.
  • While most hedge funds are both well-capitalized and opaque, most of them operate ethically and without too many systemic issues.
  • Some on the other hand, have defrauded investors of billions of dollars and even nearly brought down the global financial system.

Madoff Investment Scandal

The Bernie Madoff scandal is truly the worst case scenario for a hedge fund. Madoff was essentially running a Ponzi scheme with Bernard L. Madoff Investment Securities, LLC. Madoff was a well-respected investment professional throughout his career, although some observers questioned his legitimacy. He even served as Chairman of the National Association Of Securities Dealers (NASD), a self-regulatory organization for the securities industry, and helped to launch the NASDAQ exchange.

Madoff admitted to his sons who worked at the firm that the asset management business was fraudulent and a big lie in 2009. It is estimated the fraud was around $64 billion. Madoff pleaded guilty to multiple federal crimes of fraud, money laundering, perjury and theft. He was sentenced to 150 years in prison and a restitution amount of $170 billion. While many investors lost their money, some have been able to recover a portion of their assets.

Madoff operated his fund by promising high consistent returns he was not able to achieve. He used money from new investors to pay off the promised returns to prior investors. A number of investment professionals questioned Madoff and his alleged performance. Harry Markopolos, an options trader and portfolio manager, did substantial research and determined Madoff’s results were fraudulent. He reached out to the SEC numerous times over the years, providing evidence of the fraud. However, the SEC brushed off the allegations after minimal investigation. As of September 2015, Madoff is serving his prison term.

SAC Capital

SAC Capital, run by Steven Cohen, was one of the leading hedge funds on Wall Street with $50 billion in assets under management (AUM) at its peak. The SEC had been investigating the hedge fund for a number of years before conducting raids at offices of investment companies run by former SAC traders in 2010. A number of traders at the fund were charged with insider trading from 2011 to 2014. Former portfolio manager Mathew Martoma was convicted of conspiracy and securities fraud in 2014. In total, eight former employees of SAC Capital have been convicted.

The SEC never brought charges against Cohen personally, although it did file a civil suit against SAC Capital in 2013. SAC Capital ultimately agreed to pay a $1.2 billion fine and to stop managing outside money to settle the suit. As of September 2015, Cohen runs Point72 Asset Management, which manages his personal wealth of around $9 billion.

The Galleon Group

Galleon was a very large hedge fund management group with over $7 billion in AUM before closing down in 2009. The fund was founded and run by Raj Rajaratnam. Rajaratnam was arrested along with five others for fraud and insider trading in 2009. He was found guilty on 14 charges and sentenced to 11 years in prison in 2011. Over 50 people have been convicted or pleaded guilty in connection with the insider trading scheme.

Rajaratnam was tipped off to an investment Warren Buffet was making in Goldman Sachs by Rajat Gupta, a former director at the investment firm. Rajaratnam bought shares in Goldman before the close of the market that day. The deal was announced that evening. Rajaratnam then sold the shares the next morning making around $900,000 in profit. Rajaratnam had a similar pattern of trading with other stocks with a ring of insiders who supplied him with material information from which he was able to profit.

Long-Term Capital Management

Long-Term Capital Management (LTCM) was a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders. The firm was wildly successful from 1994-1998, attracting more than $1 billion of investor capital with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.

But the fund nearly collapsed the global financial system in 1998. This was due to LTCM’s highly leveraged trading strategies that failed to pan out. Ultimately, LTCM had to be bailed out by a consortium of Wall Street banks in order to prevent systemic contagion. If LTCM had gone into default, it would have triggered a global financial crisis due to the massive write-offs its creditors would have had to make. In September 1998, the fund, which continued to sustain losses, was bailed out with the help of the Federal Reserve. Then its creditors took over, and a systematic meltdown of the market was prevented.

Pequot Capital

Founded in 1998 by Art Samberg, Pequot capital wowed investors with annualized returns of more than 16% a year, growing to more than $15 billion under management by the mid-2000's. However, it turns out that this impressive track record was the result of insider trading. The SEC shut the fine down in 2010 and fined Samberg $28 million.

Amaranth Capital

Not all hedge funds blow up due to fraud or insider trading. Sometimes hedge funds simply have a period of spectacular bad performance. Amaranth capital was launched in the year 2000 by Nicholas Maounis and grew to just under $10 billion by 2005 after boasting annualized returns over those 5 years of a whopping 86% utilizing a proprietary convertible bond arbitrage strategy. But streaks of good luck like this often turn and revert to the mean. Just one year later, in 2006, the fund folded after some derivative bets failed to paid off and instead led to losses of more than $6.5 billion.

Tiger Funds

In 2000, Julian Robertson's Tiger Management failed despite raising $6 billion in assets. A value investor, Robertson placed big bets on stocks through a strategy that involved buying what he believed to be the most promising stocks in the markets and short selling what he viewed as the worst stocks.

This strategy hit a brick wall during the bull market in technology. While Robertson shorted overpriced tech stocks that offered nothing but inflated price to earnings ratios and no sign of profits on the horizon, the greater fool theory prevailed and tech stocks continued to soar. Tiger Management suffered massive losses and a man once viewed as hedge fund royalty was unceremoniously dethroned.

Aman Capital

Aman Capital was set up in 2003 by top derivatives traders at UBS, the largest bank in Europe. It was intended to become Singapore's "flagship" in the hedge fund business, but leveraged trades in credit derivatives resulted in an estimated loss of hundreds of millions of dollars. The fund had only $242 million in assets remaining by March 2005. Investors continued to redeem assets, and the fund closed its doors in June 2005, issuing a statement published by London's Financial Times that "the fund is no longer trading". It also stated that whatever capital was left would be distributed to investors.

Marin Capital

This high-flying California-based hedge fund attracted $1.7 billion in capital and put it to work using credit arbitrage and convertible arbitrage to make a large bet on General Motors. Credit arbitrage managers invest in debt. When a company is concerned that one of its customers may not be able to repay a loan, the company can protect itself against loss by transferring the credit risk to another party. In many cases, the other party is a hedge fund.

With convertible arbitrage, the fund manager purchases convertible bonds, which can be redeemed for shares of common stock, and shorts the underlying stock in the hope of making a profit on the price difference between the securities. Since the two securities normally trade at similar prices, convertible arbitrage is generally considered a relatively low-risk strategy. The exception occurs when the share price goes down substantially, which is exactly what happened at Marin Capital. When General Motors' bonds were downgraded to junk status, the fund was crushed. On June 16, 2005, the fund's management sent a letter to shareholders informing them that the fund would close due to a "lack of suitable investment opportunities".

Bailey Coates Cromwell Fund

In 2004, this event-driven, multistrategy fund based in London was honored by Eurohedge as Best New Equity Fund. In 2005, the fund was laid low by a series of bad bets on the movements of U.S. stocks, supposedly involving the shares of Morgan Stanley, Cablevision Systems, Gateway computers and LaBranche (a trader on the New York Stock Exchange). Poor decision making involving leveraged trades chopped 20% off of a $1.3-billion portfolio in a matter of months. Investors bolted for the doors and on June 20, 2005, the fund disolved.

The Bottom Line

Despite these well-publicized failures, global hedge fund assets continue to grow as total international assets under management amounts to approximately $2 trillion. These funds continue to lure investors with the prospect of steady returns, even in bear markets. Some of them deliver as promised. Others at least provide diversification by offering an investment that doesn't move in lockstep with the traditional financial markets. And, of course, there are some hedge funds that fail.

Hedge funds may have a unique allure and offer a variety of strategies, but wise investors treat hedge funds the same way they treat any other investment - they look before they leap. Careful investors don't put all of their money into a single investment, and they pay attention to risk. If you are considering a hedge fund for your portfolio, conduct some research before you write a check, and don't invest in something you don't understand. Most of all, be wary of the hype: when an investment promises to deliver something that sounds too good to be true, let common sense prevail and avoid it. If the opportunity looks good and sounds reasonable, don't let greed get the best of you. And finally, never put more into a speculative investment than you can comfortably afford to lose.