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Madoff

Bernie Madoff did not run a hedge fund and had no connection whatsoever to the hedge fund industry. Why do amateurs think the scandal had anything to do with hedge funds? Madoff's brokerage firm was "regulated" and fraud has been illegal for centuries. Real due diligence itself is an alpha source. Strategy diversification is mandatory for risk averse investors.

It was always odd that Madoff didn't set up a fund if he was so good. Despite his "performance", Madoff wasn't a billionaire. With those "returns" he should have been a stalwart of the Forbes 400. Why did so few question his absence from rich lists? No institutional client of mine ever sent an RFP to Madoff during a search. No professional investor anywhere in the world put a cent with him.

Below is the chart of Madoff feeder, Fairfield Sentry, versus Gateway GATEX, a mutual fund which actually does use the split-strike conversion strategy.

Bernard Madoff

Split strike conversion is a simple strategy for options traders. It is too well-known to be an edge and does NOT protect against major stock market falls. A watershed event occurred in 2001 from the potent combination of the bear market, reduced payments for order flow and decimalization. His broking income became insufficient to fund the Ponzi. 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 just five minutes in the 1990s to decide I had no interest in the Madoff "strategy". Since then many feeders invested with him have crossed my desk, often without disclosure as to who the underlying manager was. A few weeks ago two marketers approached me at investor events with "15 years of double digit returns at under 3% vol, daily liquidity" pitches. Both times I replied "No Madoff" before I heard the name. I look at alpha vendors and don't have time to study obviously irrelevant products.

Madoff did not make the first cut with competent investors. Any fund of funds that had money with him was NOT doing its job. A FOHF is mandated to invest ONLY in hedge funds not stockbrokers. I stay away from products with a big difference between what they should have made and what they did make. Back then I was simply looking around for some good funds that had navigated that challenging year successfully.

"It's a proprietary strategy"? The trouble with Madoff was that he performed too well for the split strike conversion on the S&P 100 OEX he was supposedly running. I like good black box strategies but this was no black box. I've designed options pricing and trading models and volatility arbitrage systems and it takes much heavier quantitative weaponry to generate consistent returns out of the options markets.

Going long some large cap equities, sell calls and buy puts for the collar does not protect capital in sharply 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.

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 or made a lot in that terrible month. More recently Bernie Madoff seemed remarkably immune to the market meltdown that has unfolded. The crash of October 2008 was the end. His undoing was that even products 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 reporters looked into the story seven years ago. Barrons and MAR Hedge carried some heavy hints on Bernie Madoff with well researched articles. An actual hedge fund would be delighted to be profiled by Barrons. Free advertising and read by many high net worth investors. But the curiously defensive response of Fairfield Greenwich concerning its "sought after" Madoff feeder, Fairfield Sentry, was "Why Barrons would have any interest in this fund I don't know". Rarely do investors get such a STRONG indication that things would not have stood up to close scrutiny. Kudos to Harry Markopolos who did reveal the problems and attempted to alert regulators. How could intermediaries ignore such RED FLAGS? Competent ones easily saw through Madoff.

Anyone with similar LEGITIMATE numbers could impose higher fees than the industry standard. Why was he trying to raise new money recently when every proper fund has capacity issues long 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 close to all investors long ago. And why was such a high proportion of money from overseas? I was skeptical before the earlier Princeton Economics pyramid scheme of "star managers" who don't (or can't!) raise most of their capital from local investors. Why did so few university endowments and pension plans queue up at 53rd and 3rd in New York for "access" to the master?

Bernard Madoff may not have been a skilled investor but he was a brilliant salesman. There is a reliable rule when a manager says they can make a "special case" to get you in their "closed" fund. UNDER NO CIRCUMSTANCES INVEST. Run, don't walk, away. Creating FALSE scarcity shouldn't get a fund past gatekeepers. That exclusive "capacity" with "super" managers is always 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 IPOs, are driven by sales tactics not value. Decide whether to buy into a product, 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 managers. I wonder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot understood options collar strategies or questioned the positive performance in periods when it SHOULD have done poorly. Due diligence is important but diversification even more so in case you are wrong. 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 manager would be 5%, no matter how good and only 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 reopened Medallion Fund, the world's best currently operating hedge fund (+80% 2008 return, after those "high" fees), the most I would invest is 5%. It is simply prudent protection. Concentrated manager bets are for bolder and smarter investors than me. The ONLY people who should have 100% in any one fund are the manager and employees themselves. It is ESSENTIAL alignment with clients to ensure shared downside.

A good fundamental stock picker is Warren Buffett, manager of the listed hedge fund Berkshire Hathaway. Unfortunately I had to redeem in early 2008 when I found out about his bizarre options speculation. Naked short selling index puts to collect premium was a rookie mistake far removed from his edges. The "margin of safety" skews to the buyer not the short seller and the risk/reward scenario is OPPOSITE to almost every other transaction he has ever done. Warren Buffett, the derivatives trader, should unwind those dire deals which have lost many billions, so far. When he does, the fund might be worth considering again for a new 5% allocation.

In my case I also only allocate 5% to myself to manage in certain special situations and emerging markets where I have a long established edge. My favorite investment for 2008 was actually executed in 2007. Short selling private equity by way of Fortress FIG, Blackstone BX and KKR KFN. Not often do such high 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 before 2009. Some specific emerging markets are looking VERY 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 fall 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 generalizations to a heterogenous universe. Fund managers range from the vast majority that are honest to the very rare swindler.

Skilled strategy diversification, manager selection, due diligence and portfolio optimization is the key to REAL 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 actual hedge funds. However it does emphasize the need for due diligence and broad manager AND strategy diversification.

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