Vast Under-Investment in Due Diligence

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With everyone tsk-tsking the Madoff scandal — the amount lost, the after-the-fact obviousness, the SEC incompetence — I thought now was as  good a time as any to look at the actual research, due diligence and manpower thrown at investigating managers and funds.

Not surprisingly, it is tiny — at least, when compared with the heavy lifting of equity research. The asset management and brokerage industry is vastly under-invested in due diligence; the resources applied to hedge funds and managers is a comparative pittance.

Note that every major brokerage firm — from Merrill Lynch to UBS to Morgan Stanley to Credit Suisse and beyond — offer a platform to these managers. Their managed assets group, private wealth management, (even retail brokerage) have access to these funds and managers.

And the due diligence that’s performed? It would be generous to call it weak. I was vetted a few years ago, and the items I was prepared to answer questions about — an IRS stock option issue (now resolved), a bankruptcy (someone with a similar name, not me), a few dumb items on my credit score — never came up. I was stunned how superficial the process was.

There have been more mutual funds than equities for a long time. A variety of firms, most notably, Morningstar, devote lots of resources and manpower to analyzing these funds. There are now more hedge fund managers than there are US stocks. Throw in the biggest of the individual managed account firms (like Madoff’s) and its significantly bigger.

Yet the research, resources and manpower dedicated to investigating the managers and hedge funds is a pittance of what’s applied towards researching just the S&P500 equities.

Consider these data points: The typical big firm covers at least half of the S&P500 equities. Usually, there are 3 separate divisions that do so: Asset Management, Investment Banking, and Institutional Trading. Due to compliance rules (Chinese Walls, Spitzer rules, etc.) each does a very different form of research. The research can be long-term investing/asset management focused, or it could be geared towards iBanking, or it might simply be institutional trading. This often means some bigger firms have more than one analyst covering the same individual stock.

One firm I am familiar with — let’s use a range to avoid identifying them specifically — has this headcount:

  1. Wealth Management Research: 50-75
  2. Investment Banking Research: 300-400
  3. Institutional Trading: 150-200

Let’s assume half of these people are analysts, and the rest are admin/marketing/sales.

How many people do you think they have vetting the 250-500 hedge fund and individual managers on their platform?

Under 10.

I surmise this ratio — somewhere near 25 to 1 — is typical throughout the industry.

If you want to know why a sociopath like Madoff slipped throught the cracks — as an industry, we do not dedicate enough resources to vetting managers.


Originally published at The Big Picture blog and reproduced here with the author’s permission.

5 Responses to "Vast Under-Investment in Due Diligence"

  1. Keith Davids   December 21, 2008 at 5:32 pm

    The public was under the assumption that the SEC was the police officer on duty. The public goes to sleep at night confident that their police and fireman will protect them. If they were not confident, they would not be able to sleep or would police themselves. Outside of MADOFF the SEC deserves full responsibility. This is a FAILED agency, ran by someone who does not have a clue about markets. Blatant naked shorting, removal of uptick rule and MADOFF! All COX has to show for this is a Martha Stewart conviction! What a joke! If there is one thing we have learned – it is that this has been a decade of corruption and I would not be suprised if people at the SEC are corrupt.Once again…. if we cannot trust the SEC to make sure a MADOFF scenario does not happen, then what the HELL do we need the SEC for? They have done nothing but play partner to the HEDGE FUNDS who have destroyed more WEALTH than AL-QUEDA ever could.Change? Like Obama says… I am a republican, but if OBAMA cleans up this corruption on Wall Street, and restores confidence, I’ll probably never vote Republican again.

    • Anonymous   December 21, 2008 at 6:42 pm

      I would bet the agency discouraged true analytical inquiry and that anyone who dared to tread on the feet of the powers that be whether the feet belonged to Bernard Madoff or some big mahoff at Goldman, Merrill, Citi, whereever was probably fired or demoted. The police and the policed run in the same social circles and life after the SEC could entail a lucrative job at one of the aforementioned firms. Don’t bite the hand that could feed you.

      • Anonymous   December 21, 2008 at 7:08 pm

        Oh that is a guarantee… It seems the only thing they “EXTENSIVLY ANALYZED” was the removal of the uptick rule!?I guess it makes sense to discredit all the SECs research on the removal of the UPTICK rule and NAKED SHORTING. It is now obvious that the combination of incompetence and corruption should eliminate any justification of ANY work they performed since COX was in office.

        • Anonymous   December 24, 2008 at 10:03 pm

          It goes back a long way. Greenspan tried to warn us about “irrational exhuberance” and was forcefully warned to shut his mouth. Since what he coveted above all else was approval by the rich and famous, he did so.

  2. Bill   December 25, 2008 at 8:05 am

    If each analyst at that firm had to investigate 25 funds, then the one assigned to Madoff would have had 10 days per year for that fund (since it was a bigger fund, maybe more since you might not allocate the same amount of time to funds 1/4 the size). And that’s one year and only one firm. With dozens of firms and analysts plus the SEC that could have looked at Madoff, it’s kind of shocking that Madoff kept it going so long.