Is Trio Capital Australia's own Madoff affair?

Have the recent issues raised by Trio Capital (formally Astarra/Absolute Alpha) created a mini-Madoff affair? Dominick McCormick investigates.

The situation is still developing, but some reports suggest that Australia may have spawned its very own Madoff-style scheme within Trio Capital (formally Astarra/Absolute Alpha).

While the size of the problem pales in comparison with the estimated US$65 billion involved in the US Madoff affair, the possible blow to confidence and trust in the local investment industry as more details are revealed should not be underestimated.

The problems have focused on the fund of hedge fund component, Absolute Alpha, but given its Alpha Strategic Fund (ASF) this was a significant investment of a number of the group’s other funds.

This has resulted in the freezing of all funds across the group and the appointment of an administrator to the responsible entity, Trio Capital.

Despite being on the case for more than six weeks to date, the funds administrator appears to have been unable to identify where the $118 million invested via the ASF has gone and has indicated that this fund is heavily impaired.

This suggests that at least some of this money has not been allocated to legitimate hedge fund managers (who would normally be able to confirm the amounts within hours or days at most).

There have also been some questions about the assets in a range of the group’s other schemes.

Blogger and fund manager John Hempton has been instrumental in alerting the Australian Securities and Investments Commission (ASIC) and providing some detail and history on his blog at Bronte Capital.

The Sydney Morning Herald has gradually been revealing more in what is clearly a complex situation. Given the agonizing wait for clarity it is easy to understand the frustration and fear that clients with a stake in the group’s products are experiencing.

Without jumping to any conclusions in this particular situation it is worthwhile asking how frauds/Ponzi schemes like Madoff occur. At a simplistic level there are usually two elements required:

• Greedy and unethical but sometimes quite sophisticated promoters who have no concerns about the damage they cause to the financial wellbeing of their ‘clients’;
• Gullible or poorly educated (from a purely financial perspective) investors or advisers who are prepared to give such people (albeit unaware that they are less than ethical) significant amounts of money to ‘manage’.

There have always been a high proportion of people in the first category targeting the financial services industry. Most have not needed to resort to fraudulent activities to meet their objectives.

Developing and pushing poorly structured but strictly legal products and strategies that carry excessive fees to the promoters (and distributors) is often enough — even if they inevitably prove disastrous for clients.

In this category I would put most very high-commission products, many structured products and very aggressive geared funds and strategies (where fees are also typically paid on gross assets).

The business of some less than ethical fund managers/ promoters often morphs into pure fraud when they try to hide poor performance.

The last few years have also shown that there are plenty of people in the second category around who seem to be willing to carelessly part with their own (or their clients’) funds.

These are investors/ advisers who are willing to trust untested strategies, individuals and institutions with little or no due diligence or basis for that trust. Advisers are often distracted or driven by significant conflicts or outsized commercial arrangements.

The point is that while the focus is always mostly on the perpetrators of frauds and dangerous products, these schemes can never survive without plenty of willing investors/advisers. They need to take some responsibility for enabling them to occur.

Of course almost everyone has suffered losses during the global financial crisis (GFC). But it’s one thing to have mark-to-market losses in legitimate investments (and via managers) in extremely volatile and difficult markets.

It’s quite another to experience large losses because part or all of the investments have been diverted to knowingly dodgy investments, paid away in wildly exorbitant fees or, in some cases, simply stolen.

This money simply doesn’t come back when markets or conditions improve.

Of course it is hard for the typical individual investor to work out who they can trust and who is competent from an investment management perspective.

But planners have fewer excuses. It is part of their job to discern who is appropriate to manage their clients’ money.

If they cannot do this job adequately themselves, then they should outsource it to someone who can (a quality research house, consultant, multi-manager, etc).

Even then, they still have to take ultimate responsibility and need to ensure they can trust the outsourced provider.

It is interesting that in the Trio/Astarra case it seems there were a number of financial planners willing to back Astarra generally, and Absolute Alpha/ASF specifically, with significant client funds from an early stage even when:

• The key individuals were young and relatively inexperienced. When Absolute Alpha was set up in 2005 the principals were in their late 20s with no visible track record in managing money. If you dug into their history you noticed a distinct lack of quality financial institutions.
• There was little continuity of membership in the ASF investment committee and little relevant experience managing money. They did team up with a key individual from a US hedge fund group, but that group also had a mixed history.
• There was no backing from the major research houses.
• While the research houses clearly do not always get it right (think Basis) and are sometimes criticised for business conflicts, high turnover, relative inexperience of staff and inconsistency of ratings, the lack of any major research house coverage across their product range should have been a significant red flag.
• While it seems there were two manager-paid reports by second tier research houses/consultants, these lacked any depth and were quickly out of date. A mainstream research house/asset consultant was involved with Astarra (not Absolute Alpha) for several years but it seems their role was largely limited to mainstream manager selection and asset allocation for Astarra diversified funds.
• There were also plenty of other red flags more recently. Some of these included:
• Returns seemed too good to be true. Performance of hedge funds and fund of hedge funds, on average, were down over 20 per cent in 2008 — whereas the ASF was supposedly up for the year.
• The commentaries about performance seemed inconsistent and vague about managers (indeed mentioning no manager names) and even about the type of hedge fund strategies being employed.
• There were no names of individuals mentioned in the ASF product disclosure statement. That is something a big brand name manager can get away with, but not a boutique — especially in a complex area.
• The manager took up significant space, impeccably fitted out in Sydney’s MLC centre, when the manager had minimal funds under management — certainly something to raise questions given the more frugal way most start-up fund managers commence.
• Currency hedging was hardly mentioned in the reports even though the Astarra Strategic Fund was supposedly invested mostly in offshore (US domiciled) funds. The currency gyrations in 2008 caused massive cash-flow issues for most fully hedged funds given the extent of the Australian dollar fall.

None of these red flags prove that the returns were not real or that any form of fraud/Ponzi scheme was involved — but they are certainly enough for any intelligent observer to be compelled to ask more questions or simply pass on the investment.

That is the key: you don’t have to prove fraud to avoid investing, you just have to see enough red flags to stay away.

Good planners, researchers, and multi-managers rarely get credit for it, but what one avoids is often one of the biggest components of added value.

Without external research we assume that financial planners or dealer groups using Absolute Alpha/Astarra funds had done their own research or relied on research consultants.

So what attracted groups to Astarra? After all, many planners are taking the decision to outsource some of the investment management component of their business — and that is partly what Astarra was offering through their diversified funds.

Indeed, this is a legitimate motivation as the industry moves towards model portfolios and multi-manager solutions. But why Astarra?

Perhaps some advisers were just making the common mistake of blindly following past performance. Their 2008 performance certainly looked good, but had planners really tried to understand where this performance was coming from?

One might assume that commercial considerations dominated the establishment of such relationships with little consideration of the investment competency of the people involved.

In my view, if the advisers (or their consultants) did not sufficiently understand investment markets to question the 2008 returns (especially given the other red flags) then they should not have responsibility for allocating money there in the first place.

Clearly, the sooner this industry moves to detaching payment from product providers to advisers (and research houses) the less likely these situations are to occur.

Ultimately, it will then come down to who advisers can trust to provide high quality investment solutions on an after-fee basis for their clients, rather than potentially being those who can help collect the (highest) adviser fees for them.

In general, it seems that most perpetrators of investment fraud are likeable and charismatic people, and confused victims are often quoted stating that the person involved was a “nice guy” or a “charming man” (and yes, it usually is a man!).

But people forget that charm is the essential tool of the fraudster. It is not actually required for a good investment manager (although perhaps it makes it easier to raise money).

Bernard Madoff was apparently very charming to current and prospective clients.

There is a major difference between liking someone and trusting them. The latter requires a belief in their integrity and honesty as well as their competence. The former, for some people it seems, doesn’t require any of these.

One kneejerk response to this and similar problems is for investors and dealer groups to move further towards big brand name investment and financial groups.

Emotionally this is understandable but does it really make sense?

Constraining one’s investment universe to only large, brand name fund managers, all other things equal, is likely to result in a more constrained investment universe and poorer long-term outcomes for clients.

Isn’t a better approach to devote more effort to due diligence and finding those competent managers, researchers/ consultants and multi-managers you can truly trust?

After all, history shows that big organisations are far from immune to fraud (although it is true they are usually in a better position to compensate the victims).

But smaller fund management organisations are arguably in a better situation to build real trust with advisers/ investors because there are less key people to assess, the key people tend to stay at the firm longer, there is usually greater consistency in the investment approach and the key people are more motivated for the entity to succeed (through larger shareholdings, investment in the group’s funds, more reputation risk etc).

They simply don’t have the bureaucracy and staff turnover of the larger groups that can make developing and maintaining a true trusting relationship difficult.

How do advisers develop this trust?

You firstly need to focus on the investment strategy. Does it make sense? Do they have the right team and approach to implement it?

Is the strategy and philosophy consistent across their product disclosure documents, marketing documents and performance reports?

Do they have bad periods of performance (everyone does)?

Do they admit when they get things wrong and why?

Are the backgrounds of the key people appropriate for them to be managing that strategy?

Does their approach to risk management make sense?

Once you understand the investment strategy and approach, you need to ask a lot of questions about the people. Understand their background, their history, and their motivations.

Are they in it for the long term or just looking to gather assets quickly and sell out? Is it hard to get information about the people involved? Can you get references? Try to get to know the people — but not just on the surface.

It is preferable to deal with people you like, but it is essential that this should never be the primary driver of the relationship.

Fortunately, all-out frauds are rare in the investment industry and usually easily avoidable.

Taking a blanket approach to avoid all small and midsized investment businesses because of the perceived risk of fraud (and therefore cutting down the universe of investment opportunities) is hardly working in clients’ best interests.

It is true that avoiding losses throughout the GFC has been nearly impossible. But avoiding significant levels of exposure to products that were fraudulent, or so badly structured they were almost destined to fail investors, has been achievable.

Sensible diversification at the investment level goes a long way to achieving this.

Some, however, are taking the diversification argument to extremes by saying that the key lesson of situations like Astarra/Trio is to diversify among product providers — that it was silly for financial planners to put all clients’ assets in one provider as some did with their multi-manager diversified funds.

This is the wrong lesson in my view.

Clients who are allocating most of their money to a multi-manager provider such as MLC or Frank Russell, or even those with most of their super in an industry super fund, are not seen as being silly.

What is silly is not doing sufficient due diligence to ensure the safety of client assets and the investment competence (and integrity) of the firms and people involved.

The key is being willing to value that intangible asset — integrity — more highly and to actively seek it.

Integrity is a much-undervalued asset in the financial services industry, although events of recent years are likely to push it closer to its real value over coming years. Integrity can’t be bought or faked — it can only be built up over many years of dealing with people in an open, ethical and honest manner.

Essentially, integrity can only develop through individuals — although it is possible to transfer some of that to the culture of a firm (but this is more difficult with a large firm).

While integrity is vital to our superannuation and retirement system, regulators cannot enforce it.

Dominic McCormick is chief investment officer at Select Asset Management.