Vast Under Investment in Due Diligence

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.