Lessons from the Madoff Scandal: Deciding Which Funds Are Worth an Investment

Bernie Madoff was a stock broker "managing" client accounts. He was never part of the hedge fund industry. His firm was "regulated" and fraud is already illegal. He did not charge 2 and 20 and had no prime broker, proper auditor or independent administrator. Few sophisticated investors invested directly with so many red flags. Due diligence ITSELF is an alpha source. Diversification with NUMEROUS strategies and fund managers is MANDATORY.

Despite his "performance" Bernie was not a billionaire. With those "returns" on that asset size he should have been a stalwart of the Forbes 400. The chart below (click to enlarge) is the Madoff feeder, Fairfield Sentry, versus Gateway, GATEX, a mutual fund running the same strategy. Suspicious outperformance in the 1990s went from bad to worse in 2001.

Split strike conversion is a BASIC strategy for any options trader. It is too simple AND well-known to provide an edge and does NOT protect against major stock market falls. It looks likely Madoff was subsidizing down months with brokerage commissions from early on.

Then a watershed event occurred in 2001 from the potent combination of a sustained bear market and decimalization. The broking income probably became insufficient to smooth away the drawdowns. I would guess this might be the time Bernie Madoff transformed it into a full Ponzi scheme. Certainly the divergence between the feeder fund and Gateway became startlingly wider than the previous just dubious disparity. The abnormal returns were noticed by some who pay attention and it is worth noting that two skeptical media articles appeared that year.

I was lucky. It took about ten minutes 14 years ago to decide I had no interest in the Madoff products. Since then many funds wholly or partially invested with him have crossed my desk, often without any disclosure as to who the underlying manager was. Even in November 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 the time to bother studying 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 this month. 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 to invest in 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 a few options pricing models and volatility arbitrage systems in the past and it takes heavy quantitative weaponry to generate consistent returns out of the options market.

Going long some large cap equities, sell calls and buy puts for the collar does not protect capital in steeply down markets. Contrary to "market neutral" claims, split strike conversion tends to do better in bullish conditions. 1994 was a flat year for the S&P100 with several negative months but Madoff reported 12%. His rival, Gateway, returned 5.5% which is approximately what would be expected. He 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 LTCM imploded in September 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 up 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 in a Madoff vehicle after some good journalists looked into the story over seven years ago. Barrons and MAR Hedge carried some heavy hints on Bernie Madoff with well researched articles.

A true hedge fund would normally be delighted to be profiled by Barrons. Free advertising and read by an important and influential investor base. But at the time the curiously defensive response of Fairfield Greenwich concerning its "sought after" Madoff feeder fund Fairfield Sentry was "Why Barrons would have any interest in this fund I don't know". Rarely do investors get such a clear warning that things might not have stood up to close scrutiny. Kudos to people like Harry Markopolos who did reveal the problems and attempted to alert regulators.

It was always odd that Bernie didn't set up his own hedge fund if the strategy was so good. Surely the fact that he was NOT charging incentive fees was a red flag. Anyone with similar LEGITIMATE numbers could impose far higher fees than the industry average. Why was he aggressively trying to raise new money recently when every proper single strategy fund has capacity issues well before they reach $50 billion. Of course he needed incoming cash to keep the Ponzi scheme functioning. If the numbers were real he would have needed to hard close to all investors years ago. And why was such a high proportion of money from overseas? I was skeptical years before the earlier Princeton Economics pyramid scheme of "star managers" who don't (or can't!) raise most of their capital from domestic investors. Why wasn't every US university endowment and pension plan CIO queueing up outside 53rd and 3rd to gain "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. UNDER NO CIRCUMSTANCES INVEST. Run, don't walk, away. Creating FALSE scarcity shouldn't get any 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 very sad to hear of investors who were told their money was in a diversified portfolio, only to be wiped out by one $50 billion fraud. It really does confirm the essential need for competent intermediaries, informed advice and a wide spread of manager bets. I wonder how many feeder funds like Fairfield, Kingate, M-Invest or Ascot really understood or backtested options collar strategies or questioned the positive performance of the strategy in periods when it should have done poorly. Due diligence is important but diversification even more so. There was too much trusting and not enough verification going on.

Diversification by strategy and manager is the first and unbreakable rule for any portfolio. The most I would ever put with any one manager would be 5%, no matter how good and if and only if after passing rigorous operational due diligence. If Munehisa Honma, the best hedge fund manager in world history, came back to life the most even he would get from me would be 5%. If Renaissance Technologies re-opened their Medallion Fund, the world's best currently operating hedge fund (+90% YTD 2008 return, after fees), the most I would invest is 5%. It is simply prudent protection. Concentrated strategy or manager bets are for bolder investors than me.

The ONLY people who should have 100% with one fund is the manager and employees themselves. Talking of edges, the world's best large cap fundamental stock picker is perhaps Warren Buffett, manager of the hedge fund Berkshire Hathaway (BRK.A), which is available to anyone with $3,000. Sadly I had to redeem earlier this year when I found out about his options speculation. Naked short selling long term index puts to collect "high" premium is a rookie error, far removed from his edge. Warren should unwind those disastrous trades. If and when he does, his hedge fund will be worth considering again for an allocation.

In my case I also only allocate 5% to myself to manage in certain special situations and illiquid frontier markets where I have an edge. My favorite investment this year was actually executed in early 2007; 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 apodeictic 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 markets are looking good for next year. There is also the possibility of a January 2009 "Obama rally" even if the famously "efficient" market theoretically discounted such news in early November.

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 hedge funds broke their mandate and invested with Madoff, despite his not running a hedge fund, so avoid all FOHF? Enron, Pets.com and thousands of other equities went to zero, including some "blue chips" in 2008, so avoid all stocks? Ecuador just defaulted and most countries default over time 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 100 bad apples does not mean ALL apples are bad! You can't apply homogenous thinking to such a heterogenous universe. Funds range from the vast majority that are honest to the extremely rare crook.

Skilled strategy diversification, manager selection, due diligence and portfolio optimization is the key to REAL double digit returns EVERY year at LOW risk. Most weeks 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 far 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 "fund of hedge funds" that I analyze, only one or two make it through 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 PROPER due diligence and very BROAD manager AND strategy diversification.

Comments

[otseng:]

Excellent article on lessons learned from the Madoff scandal.

2008 Dec 30 08:35 AM

[Mark Cancel...:]

You *really* expose your ignorance by calling Berkshire Hathaway a hedge fund and also by saying that Buffett made a rookie error by writing long-term puts. On the contrary, it was brilliant. He gets to invest billions of dollars of premiums for a minimum of 15 years. The *current* value of the indices is completely irrelevant to future cash flows of the investment. Sure, the *accounting* results might look bad, but they are irrelevant. The *economic* result will be a good one.

2008 Dec 30 09:03 AM

[helplessobs...:]

Buffett knows markets. The secular bear we are in will run to 2018, the puts will lose time premium and vaporize in a new secular bull we will be in at their expiration. Meanwhile GS and GE will be paying 10% on the premium he collected. All the Madoff scandal proves is easy come, easy go. Few of those rich investors worked for their money otherwise they would have invested it with care. Also feeder funds getting 2 and 20 is simply stupid any way you look at it.

2008 Dec 30 09:38 AM

[Larson:]

The author of this article is the best salesman of them all.

Since he works in the industry, he completely neglects to mention that hedge fund fees completely wipe out any "edge" one investment strategy has over another -- not to mention the double fees paid if investing in a fund of funds are an idiotic complete waste of money.

Sure, there's always the one 90% up fund when everything else is way down, as the author of this article mentions, but people win lotteries every day too. Does that mean that diversifying by purchasing lottery tickets in every state is a good idea too?

Diversification is important, but just as important is investing in NO FEE or VERY LOW FEE investment products like those sold by Vanguard and many other big fund companies.

I'm sick and tired of all the lies and hype that guys like this writer force feed down our throats every chance they get.

2008 Dec 30 09:53 AM

[Holy Cow!:]

Employees should invest 100% in the fund???
What, so they can have BOTH their income AND their investments in the same place??? How smart is that???

2008 Dec 30 10:15 AM

[Sage of Sug...:]

So many words to convey so little useful information and a lot of misinformation.

Berkshire Hathaway is a Hedge Fund?--does the author have any clue about the company's business model and structure?

Buffett has made a rookie error?--Warren's sale of the long term index puts is nothing more than an insurance policy written with an adequate premium. Buffett has been in the insurance business for over 35 years and there is probably no one else who understands the business better than he does. To a rookie, everyone looks like as rookie.

2008 Dec 30 11:06 AM

[sr9web:]

Excellent chart - thanks

2008 Dec 30 02:04 PM