Sunday :: Dec 14, 2008

Econo Fraud 101

by eriposte

I suppose the burgeoning Bernard Madoff fraud scandal is a sign of the times, but just how much of this was preventable is illustrated in a couple of articles that were published in 2001 - yes 2001, not 2008. This incident also suggests that it would more than desirable for President-Elect Obama's SEC Chair to modernize the SEC to proactively detect and combat various old and new mechanisms of investment fraud.

Via Big Picture, here are two articles from 2001 that provided early warning on Madoff. First, via Naked Shorts, here's Michael Ocrant in May 2001 (PDF) with "Madoff tops charts, skeptics ask how". It's a long article, so let me quote some portions and recommend you read the whole article (bold text emphasis is mine throughout this post).

Mention Bernard L. Madoff Investment Securities to anyone working on Wall Street at any time over the last 40 years and you’re likely to get a look of immediate recognition. After all, Madoff Securities, with its 600 major brokerage clients, is ranked as one of the top three market makers in Nasdaq stocks, cites itself as probably the largest source of order flow for New York Stock Exchange-listed securities, and remains a huge player in the trading of preferred, convertible and other specialized securities instruments.


But it’s a safe bet that relatively few Wall Street professionals are aware that Madoff Securities could be categorized as perhaps the best risk-adjusted hedge fund portfolio manager for the last dozen years. Its $6–7 billion in assets under management, provided primarily by three feeder funds, currently would put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets.

More important, perhaps, most of those who are aware of Madoff’s status in the hedge fund world are baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year.


Those who question the consistency of the returns, though not necessarily the ability to generate the gross and net returns reported, include current and former traders, other money managers, consultants, quantitative analysts and fund-of-funds executives, many of whom are familiar with the so-called splitstrike conversion strategy used to manage the assets.

These individuals, more than a dozen in all, offered their views, speculation and opinions on the condition that they wouldn’t be identified. They noted that others who use or have used the strategy—described as buying a basket of stocks closely correlated to an index, while concurrently selling out-of-the-money call options on the index and buying out-of-the-money put options on the index—are known to have had nowhere near the same degree of success.

So, how fabulous was the Madoff "strategy"?

Madoff’s strategy is designed around multiple stock baskets made up of 30–35 stocks most correlated to the S&P 100 index....


Throughout the entire period Madoff has managed the assets, the strategy, which claims to use OTC options almost entirely, has appeared to work with remarkable results.

Again, take the Fairfield Sentry fund as the example. It has reported losses of no more than 55 basis points in just four of the past 139 consecutive months, while generating highly consistent gross returns of slightly more than 1.5% a month and net annual returns roughly in the range of 15.0%.


What is striking to most observers is not so much the annual returns—which, though considered somewhat high for the strategy, could be attributed to the firm’s market making and trade execution capabilities—but the ability to provide such smooth returns with so little volatility.

The best known entity using a similar strategy, a publicly traded mutual fund dating from 1978 called Gateway, has experienced far greater volatility and lower returns during the same period.

It is clear that the skeptics were asking very good questions back then. For instance:

But among other things, they also marvel at the seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative; and the related ability to buy and sell the underlying stocks without noticeably affecting the market.

In addition, experts ask why no one has been able to duplicate similar returns using the strategy and why other firms on Wall Street haven’t become aware of the fund and its strategy and traded against it, as has happened so often in other cases; why Madoff Securities is willing to earn commissions off the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself, or conversely, why it doesn’t borrow the money from creditors, who are generally willing to provide leverage to a fully hedged portfolio of up to seven to one against capital at an interest rate of Libor-plus, and manage the funds on a proprietary basis.

These same skeptics speculate that at least part of the returns must come from other activities related to Madoff’s market making. They suggest, for example, that the bid-ask spreads earned through those activities may at times be used to “subsidize” the funds.

According to this view, the benefit to Madoff Securities is that the capital provided by the funds could be used by the firm as “pseudo equity,” allowing it either to use a great deal of leverage without taking on debt, or simply to conduct far more market making by purchasing additional order flow than it would otherwise be able to do.

And even among the four or five professionals who express both an understanding of the strategy and have little trouble accepting the reported returns it has generated, a majority still expresses the belief that, if nothing else, Madoff must be using other stocks and options rather than only those in the S&P 100.

Well, he certainly used another type of "option" called fraud - aka "operational infrastructure".

The inability of other firms to duplicate his firm’s success with the strategy, says Madoff, is attributable, again, to its highly regarded operational infrastructure. He notes that one could make the same observation about many businesses, including market making firms.

Many major Wall Street broker-dealers, he observes, previously attempted to replicate established market making operations but gave up trying when they realized how difficult it was to do so successfully, opting instead to acquire them for hefty sums.

[Indeed, says Madoff, the firm itself has received numerous buyout offers but has so far refused any entreaties because he and the many members of his immediate and extended family who work there continue to enjoy what they do and the independence it allows and have no desire to work for someone else.]

Ahh, yes, the "independence". The punch line is at the end of the article.

Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy is the strategy and the returns are the returns.” He suggests that those who believe there is something more to it and are seeking an answer beyond that are wasting their time.


The other article by Erin Arvedlund - also from May 2001 - appeared in Barrons and was rather appropriately titled "Don't Ask, Don't Tell". Wall Street Manna has posted the whole article here. Some relevant excerpts:

Two years ago, at a hedge-fund conference in New York, attendees were asked to name some of their favorite and most-respected hedge-fund managers. Neither George Soros nor Julian Robertson merited a single mention. But one manager received lavish praise: Bernard Madoff.


When Barron's asked Madoff Friday how he accomplishes this, he said, "It's a proprietary strategy. I can't go into it in great detail."

Nor were the firms that market Madoff's funds forthcoming when contacted earlier. "It's a private fund. And so our inclination has been not to discuss its returns," says Jeffrey Tucker, partner and co-founder of Fairfield Greenwich, a New York City-based hedge-fund marketer. "Why Barron's would have any interest in this fund I don't know." One of Fairfield Greenwich's most sought-after funds is Fairfield Sentry Limited. Managed by Bernie Madoff, Fairfield Sentry has assets of $3.3 billion.


The lessons of Long-Term Capital Management's collapse are that investors need, or should want, transparency in their money manager's investment strategy. But Madoff's investors rave about his performance -- even though they don't understand how he does it. "Even knowledgeable people can't really tell you what he's doing," one very satisfied investor told Barron's. "People who have all the trade confirmations and statements still can't define it very well. The only thing I know is that he's often in cash" when volatility levels get extreme. This investor declined to be quoted by name. Why? Because Madoff politely requests that his investors not reveal that he runs their money.

"What Madoff told us was, 'If you invest with me, you must never tell anyone that you're invested with me. It's no one's business what goes on here,'" says an investment manager who took over a pool of assets that included an investment in a Madoff fund. "When he couldn't explain how they were up or down in a particular month," he added, "I pulled the money out."

Clearly, there were obvious warnings back in 2001 and the SEC did nothing. Mark Gimein has an article at Slate's The Big Money discussing how one might detect these types of fraud. He says:

The key here is not looking just at how well Madoff seemed to perform. It's how consistently he seemed to be doing it. Stories in both the New York Times and the Wall Street Journal both noted the pattern. According to the stories, he seemed to make a return of 10 percent or 11 percent a year, year in and year out. And it wasn't just an annual return kind of thing. Almost every month, the WSJ story says, Madoff made somewhere between 0 percent and 2 percent. Hardly any losses, no really outsize gains.

Professional investors are taught to value steady returns—it implies that managers aren't taking excessive risks. The latest research on hedge funds, however, reveals that overly smooth returns may not indicate that the risks are small, but that they are hidden.

The key concept here, developed by MIT professor and noted hedge-fund theorist Andrew Lo, is "serial correlation." Simply put, serial correlation is the degree to which each month's returns in a fund mirror the results of the month before. A fund that returns the exact same amount every month is perfectly serially correlated. Madoff's returns were strikingly consistent month after month, year in and year out. That kind of performance—a nice, smooth line going up no matter what the market does—is a really good sign that you should look more closely.

The extraordinary thing that Lo does in the third chapter of his book Hedge Funds, published earlier this year, is to demonstrate mathematically that an excessive degree of serial correlation is a powerful indicator that the holdings of a fund aren't being reported realistically. What Lo shows from the pattern of historical returns in hedge-fund databases is that when funds' returns grow too consistent, it is a sign that the investments are either very hard to value accurately and the returns are just guesses, or, worse, that they've been manipulated in a way that smoothes them artificially. What Lo creates is a mathematical model for judging what "looks too good to be true." Lo's work turns a lot of the conventional thinking about what's safe on its head. It shows that the evenness that investors have traditionally been taught indicates safety and reliability can actually be the best sign risk is being hidden or that the data are unreliable.

Is excessive serial correlation a definitive measure of how suspicious you should be of a fund manager? No. Very smooth returns won't prove anything about a particular fund. And they don't indicate anything about some kinds of very safe investments: If your bank CD returns the same 3 percent every year—well, that's OK, nothing unusual there. But if a stock-fund manager shows the same 1 percent increases month after month, watch out. There are exceptional fund managers out there. Though decades of experience show it's very hard to beat the market, some manage it. But the ones who can do so almost invariably—it's hard to resist the baseball analogies so loved by stock market writers, so this time we'll give in—with some home runs and strikeouts. They don't hit doubles every time they go up to the plate. If they do, it's time to watch the slow-motion replay.

Prof. Lo's work is certainly worth a look but there are many other approaches that one might potentially use to detect fraud. At Big Picture, Barry Ritholz provides links to various articles discussing ways to detect fraud and observes:

Given how easily identifiable the Madoff/Ponzi scheme was mathematically, I must ask a simple question:

Does the SEC do any quantitative research ?

There is little evidence that the SEC is using any of the quantitative methods — now so common on Wall Street — for searching out and indentifying fraud.

I would suggest to the incoming head of the SEC to put together a blue ribbon of math professors, quant scientists and algo specialists to develop a few basic programs that ferrets thru market, options, and perfromance [sic] data looking for aberrational data series, and leading to criminals and fraud artists.

Sounds like a very good suggestion to me.

eriposte :: 6:57 AM :: Comments (5) :: Digg It!