Oh Sh*t...Even Index Arb Isn't Safe

When it rains, it pours so it is said. And indeed it does according to Kaminsky et.al's 2004 paper on the relationship(s) between capital flows, macro policies and the business cycle. It also duly applied in 2002 when dozens of double-digit billion corporations 'fessed up to various forms of malfeasance from diddling and manufacturing bogus research, looting the kitty by backdating options, re-striking awards at lows and so forth, to the outright fraud on a scale that would have made te likes of Alan Bond and Juergen Schneider blush.

And while the scale of AIG (it WAS a fraud!!), Madoff, and more recently Stanford Fincl might have sent even adventursome investors running for the safety of the Index Arbitrage bunkers, today, we are told by Reuters that even Index Arbitrage offers offers no comfort, with the arrest of Walsh & Greenwood for nothing less than getting caught with their snouts in their clients cookie jar, much like Pooh Bear's head was stuck in the honey pot.

The pair are accused of nothing less than "appropriating" client funds for personal use. More than 80% of assets it is believed. Undoubtedly, few will have heard of WG Trading, but like Madoff they've been around for decades, had a fine reputation believed to be running a respectable Index Arb shop. It seems however, they were buying racehorses, paying alimony, funding the remodeling at Le Cirque, buying big digs in fashionable neighborhoods, hot wheels, and everything else a Would-be Wall Street Entrepreneurial Titan should be seen to be spending it on. We know not if either had a Net-Jets fractional, or a lease on a jet-powered titanium tube with wings of their own.

Now, like Madoff, there perhaps should have been some red flags and by way of disclosure, I have no inside information or special knowledge of WG. But it is common knowledge that no one has made money out of index arb in the USA since the 1980s. Certainly not enough - after management fees to fund a Larchmont-lockjaw lifestyle of thoroughbreds, polo, and rare Aston-Martins. Index arb was a means of getting cheap stock loan inventory, having inventory (before the downtick rule) to sell long when it was in spirit, a short-sale, and having a position to to use at expiration to manipulate prices for associated option trades as necessary. It has been, in short, a dealer business since anyone who was not doing all three (like most of the broker-dealers in might now be termed "The Glory Years") wouldn't get a proverbial word in edgewise since those that had the natural axe would inevitably be better offered on the way in, and better bid on the way out. And like Madoff, when the tide went out, it became impossible to answer the questions regarding the ability to competitively fund positions as a non-bank, non-deposit-taking, non-prime-brokering institution in an era of balance-sheet reduction. Or perhaps they just burned the balance of their clients money, quite literally, on hay.

And so due-diligence just got a whole lot harder - both for investors and managers. Now, Mr Hedge Fund Manager, Mr Investor (or Mr Kroll on his behalf) will be poking around in YOUR rubbish bins. Like the French Fisc, they will be evaluating your lifestyle and working backwards to see whether or not YOUR income is commensurate with your returns. NOW, Mr Investor will want to see the audited accounts of not just the Fund, but the investment Management company. And there will be no excuse (except the embarrassment of riches) to deny such access. Mr Investor will want to know - in fact will need to know - about messy divorces and spiteful wives from hell. Yes, life in the future will be whole lot different after this one...