Bernie Madoff didn’t run a hedge fund and had no connection in any respect to the hedge fund business. Why do amateurs assume the scandal had something to do with hedge funds? Madoff’s brokerage agency was “regulated” and fraud has been unlawful for hundreds of years. Real due diligence itself is an alpha supply. Strategy diversification is obligatory for danger averse buyers.
It was all the time odd that Madoff didn’t arrange a fund if he was so good. Despite his “performance”, Madoff wasn’t a billionaire. With these “returns” he ought to have been a stalwart of the Forbes 400. Why did so few query his absence from wealthy lists? No institutional shopper of mine ever despatched an RFP to Madoff throughout a search. No skilled investor anyplace on the planet put a cent with him.
Below is the chart of Madoff feeder, Fairfield Sentry, versus Gateway GATEX, a mutual fund which truly does use the split-strike conversion technique.
Split strike conversion is an easy technique for choices merchants. It is just too well-known to be an edge and does NOT shield towards main inventory market falls. A watershed occasion occurred in 2001 from the potent mixture of the bear market, lowered funds for order move and decimalization. His broking revenue turned inadequate to fund the Ponzi. The divergence between the feeder fund and Gateway turned startlingly wider than the earlier merely doubtful disparity. The irregular returns have been observed by those that concentrate and two skeptical media articles appeared that yr.
I used to be fortunate. It took simply 5 minutes within the 1990s to determine I had little interest in the Madoff “strategy”. Since then many feeders invested with him have crossed my desk, typically with out disclosure as to who the underlying supervisor was. A couple of weeks in the past two entrepreneurs approached me at investor occasions with “15 years of double digit returns at under 3% vol, daily liquidity” pitches. Both occasions I replied “No Madoff” earlier than I heard the identify. I take a look at alpha distributors and don’t have time to review clearly irrelevant merchandise.
Madoff didn’t make the primary reduce with competent buyers. Any fund of funds that had cash with him was NOT doing its job. A FOHF is remitted to take a position ONLY in hedge funds not stockbrokers. I keep away from merchandise with an enormous distinction between what they need to have made and what they did make. Back then I used to be merely wanting round for some good funds that had navigated that difficult yr efficiently.
“It’s a proprietary strategy”? The hassle with Madoff was that he carried out too properly for the cut up strike conversion on the S&P 100 OEX he was supposedly operating. I like good black field methods however this was no black field. I’ve designed choices pricing and buying and selling fashions and volatility arbitrage techniques and it takes a lot heavier quantitative weaponry to generate constant returns out of the choices markets.
Going lengthy some giant cap equities, promote calls and purchase places for the collar doesn’t shield capital in sharply down markets. Contrary to its “market neutral” claims, cut up strike conversion performs higher in bullish circumstances. 1994 was a flat yr for the S&P 100 with a number of damaging months however Madoff reported 12%. Gateway, returned 5.5% which is roughly what can be anticipated. Madoff ought to have had comparable numbers to the mutual fund however by some means “made” double digits. That was unattainable for his “claimed” technique.
You can detect lots by specializing in troublesome durations. When Long-Term Capital Management imploded in summer time 1998, volatility was itself very risky and shares dropped sharply. But Bernie produced an identical return as in quieter months regardless of the mayhem. In September 2001, 9/11, shares gapped down and volatility gapped larger however no drawback for Madoff. Almost each actual hedge fund both misplaced or made so much in that horrible month. More just lately Bernie Madoff appeared remarkably resistant to the market meltdown that has unfolded. The crash of October 2008 was the top. His undoing was that even merchandise that have been up for the yr have been struggling redemptions.
Isn’t a media search an necessary a part of Due Diligence 101? Not many buyers would need their cash with Madoff after some good reporters appeared into the story seven years in the past. Barrons and MAR Hedge carried some heavy hints on Bernie Madoff with properly researched articles. An precise hedge fund can be delighted to be profiled by Barrons. Free promoting and skim by many excessive internet value buyers. But the curiously defensive response of Fairfield Greenwich regarding its “sought after” Madoff feeder, Fairfield Sentry, was “Why Barrons would have any interest in this fund I don’t know”. Rarely do buyers get such a STRONG indication that issues wouldn’t have stood as much as shut scrutiny. Kudos to Harry Markopolos who did reveal the issues and tried to alert regulators. How might intermediaries ignore such RED FLAGS? Competent ones simply noticed by means of Madoff.
Anyone with comparable LEGITIMATE numbers might impose greater charges than the business normal. Why was he making an attempt to boost new cash just lately when each correct fund has capability points lengthy earlier than they attain $50 billion? Of course he wanted incoming money to maintain the Ponzi scheme functioning. If the numbers have been actual he would have wanted to shut to all buyers way back. And why was such a excessive proportion of cash from abroad? I used to be skeptical earlier than the sooner Princeton Economics pyramid scheme of “star managers” who don’t (or can’t!) increase most of their capital from native buyers. Why did so few college endowments and pension plans queue up at 53rd and third in New York for “access” to the grasp?
Bernard Madoff might not have been a talented investor however he was an excellent salesman. There is a dependable rule when a supervisor says they will make a “special case” to get you of their “closed” fund. UNDER NO CIRCUMSTANCES INVEST. Run, don’t stroll, away. Creating FALSE shortage shouldn’t get a fund previous gatekeepers. That unique “capacity” with “super” managers is all the time a ruse. Most giant buyers can get direct entry to high quality managers. Yes there are some genuinely closed funds as gifted merchants know the AUM restrict for his or her technique. Why would anybody need to spend money on a fund past its optimum measurement? AUM and returns are typically negatively correlated. Too many funds, like IPOs, are pushed by gross sales techniques not worth. Decide whether or not to purchase right into a product, don’t get bought into it.
It is gloomy to listen to of buyers who have been informed their cash was in a diversified portfolio, solely to be worn out by one fraud. It confirms the important want for knowledgeable recommendation and a large unfold of managers. I ponder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot understood choices collar methods or questioned the constructive efficiency in durations when it SHOULD have executed poorly. Due diligence is essential however diversification much more so in case you’re flawed. There was an excessive amount of trusting and never sufficient verification happening.
Diversification by technique and supervisor is the primary and unbreakable rule for any portfolio. The most I might ever put with any supervisor can be 5%, regardless of how good and solely after passing rigorous operational due diligence. If Munehisa Honma, the most effective hedge fund supervisor in world historical past, got here again to life probably the most even he would get from me can be 5%. If Renaissance Technologies reopened Medallion Fund, the world’s greatest at present working hedge fund (+80% 2008 return, after these “high” charges), probably the most I might make investments is 5%. It is just prudent safety. Concentrated supervisor bets are for bolder and smarter buyers than me. The ONLY individuals who ought to have 100% in anybody fund are the supervisor and staff themselves. It is ESSENTIAL alignment with shoppers to make sure shared draw back.
A superb elementary inventory picker is Warren Buffett, supervisor of the listed hedge fund Berkshire Hathaway. Unfortunately I needed to redeem in early 2008 once I came upon about his weird choices hypothesis. Naked brief promoting index places to gather premium was a rookie mistake far faraway from his edges. The “margin of safety” skews to the customer not the brief vendor and the danger/reward state of affairs is OPPOSITE to virtually each different transaction he has ever completed. Warren Buffett, the derivatives dealer, ought to unwind these dire offers which have misplaced many billions, up to now. When he does, the fund may be value contemplating once more for a brand new 5% allocation.
In my case I additionally solely allocate 5% to myself to handle in sure particular conditions and rising markets the place I’ve an extended established edge. My favourite funding for 2008 was truly executed in 2007. Short promoting private equity by means of Fortress FIG, Blackstone BX and KKR KFN. Not typically do such excessive absolute returns supply themselves up so simply and generously. The implosion of massive personal fairness was a uncommon instance of an apodictic certainty in finance. The brief positions at the moment are so small they’re hardly value masking. That’s the difficulty with profitable shorts however I’ll purchase to cowl earlier than 2009. Some particular rising markets are wanting VERY good for subsequent yr.
Most funds is probably not value investing in however a tiny few are frauds and with correct checks and balances they’re ALWAYS avoidable. Don’t spend money on any fund managers due to Bernie Madoff? Some funds of funds invested with Madoff so keep away from all of them? Enron, WorldCom and hundreds of different equities fall to zero, together with some “blue chips” in 2008, so keep away from each inventory? Ecuador, Iceland and Seychelles are bankrupt so keep away from ALL authorities bonds? House costs are falling and actual property scams have been round for hundreds of years so keep away from all actual property? One dangerous apple and even 100 hundred dangerous apples doesn’t imply ALL apples are dangerous! You can’t apply homogenous generalizations to a heterogenous universe. Fund managers vary from the overwhelming majority which are trustworthy to the very uncommon swindler.
Skilled technique diversification, supervisor choice, due diligence and portfolio optimization is the important thing to REAL returns EVERY yr at LOW danger. Most days I take a look at many funding merchandise purporting to supply a constant absolute return. The first query I ask myself is whether or not it truly is a hedge fund. That doesn’t take lengthy and eliminates many. The second query is whether or not it’s a GOOD hedge fund. That is harder, takes for much longer and removes many extra. The third query is whether or not I might truly make investments or advise anybody else to. That course of takes months. In common for each 100 hedge funds or funds of hedge funds that I analyze, just a few make it to choice.
The Bernard L. Madoff Investment Securities scandal has NOTHING to do with the worth to portfolios of excellent precise hedge funds. However it does emphasize the necessity for due diligence and broad supervisor AND technique diversification.
by Veryan Allen. Copyright
SOURCE: Hedge fund – Read whole story here.