Madoff $65 billion Trap.  A study in unlikely hedge fund economic returns
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Madoff $65 billion Trap. A study in unlikely hedge fund economic returns

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This is a follow up analysis after reading "No One Would Listen" by Harry Markopolos. It reviews in detail the claims Madoff made in terms of his supposed investment strategy. And, how Markopolos ...

This is a follow up analysis after reading "No One Would Listen" by Harry Markopolos. It reviews in detail the claims Madoff made in terms of his supposed investment strategy. And, how Markopolos debunked all that. I also gathered the data firsthand and elaborated on this type of analysis.

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Madoff $65 billion Trap.  A study in unlikely hedge fund economic returns Madoff $65 billion Trap. A study in unlikely hedge fund economic returns Presentation Transcript

  • Madoff $65 billion Trap Gaetan “Guy” Lion May 2010
  • Introduction Harry Markopolos wrote a book about his uncovering the $65 billion Bernie Madoff Ponzi scheme; and, how the SEC never caught Madoff. That’s despite Markopolos sharing his detailed findings with them in 1999, 2000, 2001, 2005, and 2007. This presentation is an analytical review of Markopolos findings and other fraud detection methods.
  • Losses to Investors In a Ponzi scheme, the earlier investors get repaid by the later ones. So, it is not like the entire $65 billion was lost. Investors invested $36 billion in Madoff funds. They got back $18 billion. They lost $18 billion. They also thought they reaped $29 billion in gains that never existed.
    • Let’s look at a couple of fraud detection methods that would not have worked…
  • Benford’s Law used in Fraud Detection Software This test would not have uncovered Madoff’s Ponzi scheme. The Gateway Fund (GATEX) used a strategy most similar to Madoff. It is a benchmark on how Madoff’s fund should have looked if it had been legit.
  • Detecting Fraud using Serial Correlation The greater the serial correlation of monthly returns the more probable such returns are manipulated to deliver smoothed return. Madoff’s low negative correlation does not raise a red flag.
    • To catch this Ponzi scheme, you had to understand what Madoff was claiming to do…
  • Bernie Madoff claimed strategy His “split strike conversion” strategy amounted to reducing stock returns volatility. He (supposedly) did this in three steps: 1) He bought 35 large cap stocks. 2) He bought S&P 100 Put options to reduce losses; and 3) He sold S&P 100 Call options to finance the premium he paid for the Puts.
  • So, he has a long position in stocks He bought stocks at prices where the two lines cross. If stocks go up on the horizontal line he makes money (on the blue line) and vice versa.
  • He buys Puts to reduce losses The Put strike price is at the red line inflection point. If stock prices along the horizontal line decline (moving to the left) of the strike price, the Put is in the money and will cover additional losses. Buying a Put establishes a floor on losses.
  • He sells Calls to finance the Puts premium The Call strike price is at the green line inflection point. If stock prices along the horizontal line increase (moving to the right) of the strike price, the Call is in the money. This creates a cap on returns because you are forced to sell the stock at the strike price. This is to earn a premium on the Call to finance the Put premium.
  • Net result is much lower volatility Selling the Calls sets a low Ceiling on stock returns gains. Buying the Puts sets a Floor on stock return losses. Now the return profile looks very different than simply being long the stocks.
  • Problem: Skewness For the same premium level, you have to retain greater losses on the Put (red box top graph) than the gains you can retain on the Call (green box below). Skewness is really bad for a split strike conversion strategy. Skewness implication : Premium paid = Premium earned Losses retained > Gains retained
  • Skewness on May 24, 2010 For about $6 you could sell a Call with a strike price of 510 on the S&P 100. This is 16.1 points away from the S&P 100 current level at the time of 493.9. You could use this $6 to buy a Put with a strike price of 455 or 38.9 points away from the current S&P 100 level. The distance of the Put strike price is more than 2 x the one of the Call strike price (38.9/16.1). That’s bad.
  • Another Problem: mismatch between the risk basis (specific stocks) vs the hedge basis (Puts S&P 100 Index)
    • Madoff was long 35 stocks;
    • He bought Puts on the S&P 100 index;
    • It would be inevitable that he would run into losses on specific stocks;
    • And, he was not protected against any specific stock losses. He was only protected against the index dropping. This should have caused Madoff to incur monthly losses more frequently than he did.
  • Percent of month with loss?! Markopolos states that Madoff’s record from 1993* to 2008 is unheard of in the hedge fund industry. 93.5% month gain… only 12 months losses out of 186 months. His loss frequency is only a fraction of the Gateway Fund (GATEX) that followed a similar strategy. And, that was during a wrenching time for capital markets including the 1997-1998 Asian currency crisis, the three year dot.com crash (2000-2002), and the onset of the financial crisis (2007 onward). *Data for GATEX goes only back to 1993. So, we cut off the time series at this point to make it comparable between Madoff and GATEX.
  • Madoff Expected Returns: Near Risk Free Rate To avoid almost all monthly losses, Madoff would have to have his Put strike price very close to the current price. This takes him almost out of equity returns and leaves him barely with a Risk Free Rate (and even less if you factor skewness and basis risk).
  • Gap between expected vs “actual” returns The red line shows the cumulative growth for Fairfield Sentry, the largest feeder fund that was 100% invested with Madoff. So, it is a perfect window into Madoff’s claimed record. Markopolos knew immediately one can’t follow Madoff’s strategy and earn a multiple of the Risk Free Rate. Also, the near perfectly straight line with such a high positive slope was another give away for Markopolos. With higher slope (returns) comes higher volatility.
  • That’s High Returns!? Those returns are a lot higher than what Markopolos expected (near the Risk Free Rate).
  • That’s Consistency!? The Fairfield/Madoff fund perfectly side steps the Dot.com bubble and the housing/financial crisis.
  • And, no one can duplicate his returns!? Gateway Investment Fund (GATEX) used a similar but superior strategy to Madoff, but it did not come close to replicating his risk-adjusted returns.
  • An Efficient Frontier Map This is a map of the combination of volatility (x axis) and return (y axis). GATEX that was expecting to do better than Madoff is already above the Efficient Frontier, reflecting a strong performance. But, Madoff’s returns are way above the Efficient Frontier. Can you beat the Efficient Frontier? Yes, but not by that much!
  • Madoff had to earn 15% before fees! Madoff was giving away the entire Hedge fund fee structure to Fairfield Sentry. This includes a performance fee of 20% of returns and a yearly management fee of 1%.
  • Markopolos knew this was a Ponzi Scheme
    • Investors thought Madoff’s returns were due to:
    • Market timing based on a proprietary model;
    • Front-running (placing his orders ahead of his clients to extract illicit gains).
    Markopolos knew it was a Ponzi scheme for a simple reason. Madoff’s equity positions were 10 times or more larger than the market for S&P 100 index options that he claimed to use for his hedges.
  • How did Madoff succeed for so long?
    • As an investor wouldn't you like to earn 11% nearly risk free? And, doing that with the former Chairman of the NASDAQ who also has a well established broker/dealer business.
    • As a feeder fund wouldn’t you like to retain the entire hedge fund compensation (1%/20%) and market to your client a world beating manager (11% nearly risk free)?
  • Who did no t invest with Madoff?
    • The vast majority of U.S. investment and commercial banks did not invest with Madoff. The head of derivatives at such institutions all concurred it had to be a Ponzi scheme.
    • This is not true for European banks. Many of them got caught with exposures ranging from $200 million to $2 billion.
  • Financial Crisis & Lehman Chapt. 11 take out Madoff $8 billion investors redemption requests Lehman Chapt. 11 on 9/15/08 Lehman files chapter 11 on September 15, 2008. Within next couple of months, the S&P 500 loses 30% of its value. Investors flee to Treasuries. 10 Yr. Treasuries yield drop by 175 bp. Investors request $8 billion in redemptions from Madoff. He is arrested on December 11, 2008.
  • The Four Red Flags summary
    • This option strategy should have earned close to the risk free rate. T-Bills over the period earned less than 4%. Madoff earned close to 11%. Impossible .
    • His mismatch between his risk on specific stocks and hedges using S&P 100 options should have caused frequent monthly losses. Instead, he incurred losses in only 6% of the months. Impossible .
    • The skewness in option prices dictates he could not simultaneously achieve: i) net zero hedging costs; and ii) avoiding all losses on the S&P 100. Impossible .
    • The size of his equity portfolio was always a high multiple of the entire market for S&P 100 options he claimed to use for hedging. Impossible .
  • Appendix section
  • Yearly returns For the S&P 500, we used a low cost index fund, Vanguard Index Trust 500 (VFINX) to render the series more realistic by factoring a few basis points of operating costs. Notice the slope with the S&P 500 also called Beta. For Madoff it is only 0.10. Yet, Madoff still beats the S&P 500 handsomely and incurs only 19% of the risk of the S&P 500 (3.83%/20.3%).
  • Distribution of Monthly returns 89% of Madoff (Fairfield) monthly returns are concentrated around just two buckets (0 to 1% and 1% to 2% per month). The same two buckets account for only 62% of GATEX’s monthly returns. It was Madoff’s combination of high returns (close to 1% p.m.) with low volatility (yearly standard deviation of 3.83%) that rendered his risk-adjusted returns surreal.