Bernie Madoff?
May 31st, 2009
Bernard Madoff did NOT run a hedge fund. He was a stockbroker “managing” customer accounts. His firm was “regulated” and fraud is already illegal. REAL due diligence ITSELF is an alpha source. Few sophisticated investors had cash with Madoff since he failed basic checks. PROPER diversification with GENUINELY uncorrelated strategies and managers is MANDATORY for risk averse investors.
The Madoff scandal has no connection to absolute return. No incentive fees, no prime broker, no proper auditor and no independent administrator. The chart below is Madoff feeder fund, Fairfield Sentry, versus Gateway GATEX, a fund with the SAME strategy. Suspicious numbers and serial correlation in the 1990s got worse in 2001.
Split strike conversion is a BASIC strategy for options traders. It is too simple and well-known to be an edge and does NOT protect against major stock market falls. It looks like Madoff was subsidizing losing months with brokerage commissions from early on. Then a watershed event occurred in 2001 from the potent combination of a sustained bear market, reduced payment for order flow and decimalization. The broking income probably became insufficient to smooth away drawdowns. The divergence between the feeder fund and Gateway became startlingly wider than the previous merely dubious disparity. The abnormal returns were noticed by those who pay attention and two skeptical media articles appeared that year.
I was lucky. It took five minutes over 14 years ago to decide I had no interest in the Madoff “strategy”. Since then many feeders wholly or partially invested with him have crossed my desk, often without any disclosure as to who the underlying manager was. Even a few weeks ago two marketers approached me at separate institutional investor conferences with “15 years of double digit returns at under 3% vol, daily liquidity” pitches. Both times I replied “No Madoff” before I had heard the manager’s name. I look at REAL hedge funds and don’t have time to study obviously unsuitable investments any closer.
Bernie did not make the first cut with most professional investors. I didn’t know for sure that Madoff was a fraud until now. But I do know a little about options and stay away from funds with a big difference between what they should have made and what they did make. Back in Christmas 1994 I was simply looking around for some good funds that had navigated that challenging year successfully. The trouble with Madoff was that he performed too well for the split strike conversion strategy on the S&P 100 OEX he was supposedly running. I like good black box trading strategies but this was no black box. I’ve designed options pricing models and volatility arbitrage systems and it takes much heavier quantitative weaponry to generate consistent returns out of the options markets.
Despite his “performance”, Bernie wasn’t a billionaire. With those “returns” on that AUM he should have been a stalwart of the Forbes 400. Why did his clients not question his absence from the list? Going long some large cap equities, sell calls and buy puts for the collar does not protect capital in steeply down markets. Contrary to its “market neutral” claims, split strike conversion performs better in bullish conditions. 1994 was a flat year for the S&P 100 with several negative months but Madoff reported 12%. Gateway, returned 5.5% which is approximately what would be expected. Madoff should have had similar numbers to the mutual fund but somehow “made” double digits. That was impossible for his “claimed” strategy in 1994.
You can detect a lot by focusing on difficult periods. When Long-Term Capital Management imploded in summer 1998, volatility was itself very volatile and stocks dropped sharply. But Bernie produced a similar return as in quieter months despite the mayhem. In September 2001, 9/11, stocks gapped down and volatility gapped higher but no problem for Madoff. Almost every real hedge fund either lost a lot or made a lot in that terrible month. More recently Madoff seemed remarkably “immune” to the stock market meltdown that has unfolded over the last 18 months. The crash of October 2008 was the end. His undoing was that even funds that were UP for the year were suffering redemptions.
Isn’t a media search an important part of Due Diligence 101? Not many investors would want their money with Madoff after some good journalists looked into the story more than seven years ago. Barrons and MAR Hedge carried some heavy hints on Princeton Economics pyramid scheme of “star managers” who don’t (or can’t!) raise most of their capital from domestic investors. Why did so few US university endowments and pension plans queue up at 53rd and 3rd in New York to gain direct “access” to the master?
Bernard Madoff may not have been a skilled investor but he was a brilliant salesman. There is a reliable rule with any fund when a manager says they can make a “special case” to get you in a “closed” fund. UNDER NO CIRCUMSTANCES INVEST. Run, don’t walk, away. Creating FALSE scarcity shouldn’t get a fund past competent gatekeepers or fiduciaries. That exclusive “access” or “capacity” with “super” managers is a ruse. Most large investors can get direct access to quality managers. Yes there are some genuinely closed funds as talented traders know the AUM limit for their strategy. Why would anyone want to invest in a fund beyond its optimal size? AUM and returns tend to be negatively correlated. Too many funds, like stocks, are driven by sales tactics. Decide whether to buy into a fund, don’t get sold into it.
It is sad to hear of investors who were told their money was in a diversified portfolio, only to be wiped out by one fraud. It confirms the essential need for informed advice and a wide spread of manager bets. I wonder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot really understood options collar strategies or questioned his positive performance in periods when it SHOULD have done poorly. short selling private equity by way of Fortress FIG, Blackstone BX and KKR KFN. Not often do such absolute returns offer themselves up so easily and generously. The implosion of big private equity was a rare example of an apodictic certainty in finance. The short positions are now so small they are hardly worth covering. That’s the trouble with successful shorts but I will buy to cover soon. Some specific emerging markets are looking good for next year.
Most funds may not be worth investing in but a tiny few are frauds and with proper checks and balances they are ALWAYS avoidable. Don’t invest in any fund managers because of Bernie Madoff? Some funds of funds invested with Madoff so avoid all of them? Enron, WorldCom and thousands of other equities went to zero, including some “blue chips” in 2008, so avoid every stock? Ecuador, Iceland and Seychelles are bankrupt so avoid ALL government bonds? House prices are falling and real estate scams have been around for centuries so avoid all real estate? One bad apple or even 100 hundred bad apples does not mean ALL apples are bad! You can’t apply homogenous generalization to a heterogenous universe. Fund managers range from the vast majority that are honest to the very rare swindler.
Skilled strategy diversification, manager selection, DEEP due diligence and portfolio optimization is the key to REAL double digit returns EVERY year at LOW risk. Most days I look at many investment products purporting to offer a consistent absolute return. The first question I ask myself is whether it actually is a hedge fund. That doesn’t take long and eliminates many. The second question is whether it is a GOOD hedge fund. That is more difficult, takes much longer and removes many more. The third question is whether I would actually invest or advise anyone else to. That process takes months. In general for every 100 “hedge funds” or “funds of hedge funds” that I analyze, only a few make it to selection.
The Bernard L. Madoff Investment Securities scandal has NOTHING to do with the value to portfolios of good hedge funds. However it does emphasize the need for REAL due diligence and BROAD manager AND strategy diversification.
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