Inside investment: Lessons from Madoff

The story of Brewster’s millions has been adapted many times from the original 1902 novel. Perhaps the best known is the film version starring Richard Pryor and John Candy. The story is a simple one: in order to inherit $300 million Pryor must first lose $30 million in 30 days. If only he had known about Bernie Madoff, the King Midas in reverse of New York’s Upper East Side. $30 million would have been a mere bagatelle to Bernie, who seems to have burnt his way through a staggering $65 billion.

At first blush this tawdry tale of fraud and malfeasance tells us nothing about the mainstream world of asset management. However, Madoff’s promise of respectable, though not spectacular, returns with little volatility is just what many investors crave. Anyone who has worked in finance for more than five minutes will have seen a presentation for a fund with a return profile (usually of a model portfolio) that slopes diagonally upward from left to right across a chart in a smooth line with few losing periods or serious drawdowns. Real life impedes when the model goes live.

Madoff preyed on this desire for stable risk-adjusted returns. He probably noticed the burgeoning obsession with measures such as the Sharpe ratio (expected return, minus the risk-free rate, divided by the standard deviation of returns) and decided to give people what they wanted. Intuitively a high Sharpe ratio is a good thing. But the number is too easily manipulated, too backward looking and too data dependent. This is especially true in the relatively opaque and youthful industry of hedge funds where Bernie chose to hang out his shingle. When researchers first started rifling through the databases on hedge fund performance in the 1990s they thought they had found a miracle asset class that did exactly what it promised: to deliver good risk-adjusted returns that were relatively uncorrelated with other asset classes. Then problems started coming to light.

First, there was inherent survivorship bias – only the good hedge funds were still around. Second there was a selection bias. A manager running multiple portfolios would choose the fund with the best risk-return profile to submit to the databases. One corollary of survivorship bias was the nasty habit of hedge funds to suffer intermittent existential crises. In the jargon, they are more exposed to fat-tail risks.

Even once these problems were well understood, others persisted. Some hedge fund strategies are essentially skill-less. For example, options overwriting can collect premium-like income for long periods until some catastrophic market event means all those returns are given back (the collar strategy Madoff claimed to use is a variation on the theme). While they are still alive these funds will have super-sharp Sharpe ratios. Other strategies might be characterized as skill-lite, such as convertible bond arbitrage, which is capturing a well-understood market beta.

Attrition rate

Unfortunately separating the wheat from the chaff is not easy. Most hedge funds report monthly or quarterly net asset values. For a statistic such as a Sharpe ratio to be truly meaningful, hundreds of observations are needed. Those fat tails make this unlikely. The standard attrition rate for hedge funds is approximately 20% a year. Some experts believe that in the present crisis the industry will shrink by 50%.

Those funds that survive will have at least demonstrated intestinal fortitude. The past few years have been a hell of a ride. Among the survivors there are undoubtedly skilled managers that are genuinely able to produce alpha. But for investors the dilemma remains, how can they be identified? The traditional answer has been to outsource to a fund of hedge funds manager. However, even with a generous additional layer of fees (typically 1% flat and 10% above a performance benchmark) many of these soi-disant experts were duped by Madoff.

Funds of hedge funds that have sold themselves on cosy relationships and access to the best and brightest will face a challenging environment. Greater quantitative rigour would be one step forward. Harry Markopolos, the Madoff whistleblower, was able to demonstrate that the fund was likely a fraud by modelling what the strategy purported to do and finding it wanting.

What quants need more than anything else are data. To really lift the lid on hedge funds, far greater transparency than managers have traditionally been comfortable with will be required. Third parties acting in a fiduciary capacity charged with pulling together portfolios of hedge fund managers should demand to look through the strategy to see all of its moving parts.

That should be the hurdle that institutional investors set. Regulators, too, will doubtless have their say. In the meantime a little common sense will go far. Neatly sloping return profiles should strike terror in the heart of investors. If something looks too good to be true, it usually is. We should pity the victims of ponzmeister Madoff but also learn from their mistakes.

Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own