By Michael Lewitt, Editor, The HCM Market Letter
"At a late stage [of a bubble], speculation tends to detach itself from really valuable objects and turn to delusive ones. A larger and larger group of people seeks to become rich without a real understanding of the processes involved. Not surprisingly, swindlers and catchpenny schemes flourish."
Charles Kindleberger[1]
One would think that an investor who claims returns that are too good to be true and refuses to disclose how he produces them would no longer be capable of fooling so-called sophisticated investors in this day and age. Bernie Madoff was not the only manager making such claims, although he was one of the very few that claimed to be surviving 2008's market collapse unscathed. The sad truth of the Madoff affair is that there were years of warning signs extant for anybody willing to stand apart from the crowd and question the fairy tale. That might have gotten you kicked out of the Palm Beach Country Club, but social approbation is one of the most over-rated virtues in this world. It is also one of the most expensive.
Madoff's Fund Business: Catalogue of Hedge Fund "Worst Practices"
Mr. Madoff's fund business was a virtual catalogue of hedge fund "worst practices." The funds employed a nondescript accounting firm called Friehling & Horowitz that worked out of a small office in Rockland County, New York.[2] The funds provided their own custodial, clearing, administrative and back office services, rendering independent verification of trade data impossible. When asked how he generated his returns, Madoff refused to answer by claiming that his investment strategy was "proprietary," a ploy that many other hedge fund managers hide behind. Mr. Madoff told the press, "I'm not interested in educating the world on our strategy, and I won't get into the nuances of how we manage risk," and "the strategy is the strategy and the returns are the returns." [3] Even his lies were lies.
According to an article in Mar/Hedge that appeared in May 2001 questioning the reality of Mr. Madoff's returns, his investment strategy involved buying a basket of stocks closely correlated with an index and simultaneously selling out-of-the-money call options and buying out-of-the-money put options on the index.[4] The strategy was designed around a stock basket of 30-35 stocks most correlated to the S&P 100 index. Mr. Madoff was the only known user of this strategy to produce consistently positive returns. Over one 139-month period ending in early 2001, his funds reportedly lost no more than 0.55 percent in four of those months while generating consistent monthly returns of 1.5 percent a month. Mr. Madoff made money even in the worst of times, and it was roughly the same amount of money he made in the best of times. The odds of anybody producing such returns are virtually zero. That is why anybody who attempted to duplicate these returns was unable to even come close.
"Why Can't You Make Me One Percent a Month, Like Bernie Madoff?"
Decades of consistent monthly returns were sufficient to convince us years ago that whatever Mr. Madoff was doing to make money for his clients, he surely wasn't investing it. In the late 1990s, when HCM was managing a fixed income hedge fund, we heard over and over again during visits with potential investors that they were entrusting their money to Bernie Madoff because he was making them money every month. It was very discouraging to hear over and over again the same question: "Why can't you make me one percent a month like Bernie?" We knew why and now they know why. We are genuinely sorry they had to learn the truth about investing in such a painful manner. The world is filled with volatility and fat tails, and even the best managers are subject to reversals. We don't write The HCM Market Letter for our health. We write it to help us understand the markets and to share that understanding with our readers in the hope that they can benefit from our education. At the end of a year in which our darkest thoughts have unfortunately not proved dark enough, we can only express our frustration that investors continue to repeat the same mistakes and lose fortunes in the process.
Bernie Madoff was a legend in the hedge fund industry. His downfall, coming at this particular time, is likely to cause incalculable damage to investors' already shaky confidence in an industry that has served its managers far better than its investors. The scheme came apart after Mr. Madoff's investors submitted redemption notices for $7 billion of their funds. HCM can say with a high degree of certainty that this will not be the last fund fraud revealed as a result of the flood of redemption requests hitting hedge funds in this annus horribilis. Madoff's firm only became a registered investment adviser and very possibly had yet to be inspected by the Securities and Exchange Commission. But the SEC had been warned by more than one investor about their suspicions before, and at some point the agency is going to have to figure out how to do its job effectively. The excuse that "fraud is difficult to detect" just isn't going to cut it anymore.
Among Mr. Madoff's victims was the highly regarded Fairfield Greenwich Group, whose $7.3 billion Fairfield Sentry Fund was one of Madoff's early "feeder funds" and boasted 15 years of 11 percent annual return. The firm is highly unlikely to survive the disclosure that it has been funding a Ponzi scheme for the past two decades. At best, Fairfield Greenwich is looking at years of expensive and painful litigation.
1 Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises Revised Editiion (New York: Basic Books, 1989 ed.), p 20.
2 This is reminiscent of the fraud that was uncovered at Bayou funds run by the now imprisoned Samuel Israel III, which employed their own "in-house" accounting firm.
3 Michael Okrent, "Madoff tops charts; skeptics ask how," MAR/Hedge, No. 89, May 2001.
4 Michael Okrent, "Madoff tops charts; skeptics ask how," MAR/Hedge, No. 89, May 2001.
