Assets don't grow in a straight line

I thought I would share a simple chart with you – an illustration of performance of $1,000 (Dh3,670) first invested back in 1992 in a certain absolute return fund, managed out of a certain Manhattan office.

At first glance this could be considered a feast for the eyes of the typical prudent investor – good year-on-year returns, growing steadily across a fifteen year time span. Capital has not simply been preserved, it has been enhanced magnificently – $1,000 invested in 1992 had growth to about $7,500 in 2007.

Indeed, as the chart shows, the gains have been booked despite the generally poor performance of the S&P 500 during the last few seven or eight years.

But let me quickly explain where the chart comes from. Defender, the fund illustrated here, was one of the key components of Madoff Securities, the low-profile hedge fund whose founder, Bernie Madoff, is now helping the FBI with their enquiries.

You will have read lots of eye-widening detail on the matter elsewhere in this newspaper, but if you want a salutary lesson to take away personally, I think this chart is key.

There is one simple thing to notice: the performance of the Madoff funds climbed steadily in a straight line. Notice the near-complete absense of bumps, up or down. Yes, it is obvious when you think about it – and we are looking at this with the benefit of hindsight – but financial assets do not grow in a straight line. They go up and down, sometimes painfully so.

Madoff reported small but inflation-beating returns month after month after month – and Bernie Madoff now stands accused of falsifying those returns year in, year out. It's an old cliché – but it also happens to be accurate: if something looks too good to be true, it usually is.

No money manager, whatever his skills, can defy financial gravity over the long term. Full stop.

There will be wealthy investors the world over who look at this chart and feel a sense of panic. The investment world is full of such impressive performance claims. And this is where the Madoff affair – quite surreal at first glance – will become very real indeed.

I suspect that once the repercussions are digested, this matter will spark a fresh rush to safety among investors in all financial assets. It is about trust – and the human instinct to preserve what you have got and ask questions later will led to huge withdraws of money across the hedge fund and private equity world.

Skillfull and unquestionably honest fund managers – already hit by extreme levels of redemptions over recent months – will be hit by a new round of nervous investors asking for their money back. Fright will cause normally calm souls to take flight from anything other than plain vanilla investments.

That, in turn, will cause fresh angst for financial markets generally, since the ongoing rush away from what used to be called "alternative" investments will accelerate the process of deleveraging that has been underway for the past sixteen months or so.

There will be no let up in the pain – and those, including myself, who thought we might have seen the worst of this crisis, may well see our hopes dashed yet again. It will also tighten the certainty that the financial world will have to live with a much-enhanced level of supervision and regulation in the future. The boom years were characterised by a regulatory-lite philosophy that said that while unsophisticated investors – regular members of the public – needed close protection, professional investors and wholesale market participants, could look after themselves.

The philosophy seemed to suit everyone involved. Retail protection ensured that a financial scandal did not become a political catastrophe, while professional freedom kept costs down and encouraged innovation. Sadly, too much of that innovation has proved to be of the questionably-creative type.

Expect firm rules, rather than broad-brush guidelines and principles. Expect a further concentration of auditing oversight and legal baggage. A safer financial world is not necessarily more satisfying to live in. But I suspect, in the years ahead, we will have little choice.

Warren Buffett, the famous American investor, remarked a little while back that once the tide went out we would see who has been swimming without any shorts on. Clearly, the tide is now receding at a frightening pace.


- Paul Murphy is an Associate Editor with the Financial Times