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Risk management: Madoff returns made up

Do end investors, be they feeder funds or funds of hedge funds, or indeed any party offering advice on investing in hedge funds, properly understand the strategies being run? The Madoff case has thrown light on the fact that even the simplest of strategies are clearly not understood by end investors.

Research by risk management firm Riskdata points out that Bernie Madoff clearly stated that his equity hedge fund employed a "split strike conversion". However, a simple replication of that strategy showed that his advertised returns were impossible to achieve. The risk profile of Madoff’s fund was inconsistent with the returns he was claiming to make.

"Suspiciously, the only way to replicate Mr Madoff’s performance is to invest in his funds!"

Riskdata

When you look back, say the authors of Riskdata’s Madoff case research, long/short equity hedge funds that reported data to HFR can be divided into two distinct buckets: funds whose risk profile is close to that of Madoff, and all the others. "Most of the funds close to Madoff’s risk profile were either directly managed by Madoff, or feeders of his funds," says the report. "Moreover this group are all extremely highly correlated with each other – typically above 95% correlation. Suspiciously, the only way to replicate Mr Madoff’s performance is to invest in his funds!" Some investors had tried to replicate Madoff’s strategy and when large discrepancies between his stated returns and their mimicked returns arose, they did not invest, says Riskdata.

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