Study uncovers large inconsistencies in Madoff investments

Date: Thursday, January 8, 2009
Author: David Walker, Wealth Bulletin

Documents showing details of Bernard Madoff's funds highlighted major discrepancies that should have acted as warning signals to investors, including returns inconsistent with his investment strategy but consistently beating his peer group, a surprising lack of large companies among his investments, and a market for US share derivatives simply too small to build the hedges he claimed to use.

A study of the documents by New York hedge fund research company Infovest21 showed Madoff's funds suffered neither losing years nor losing quarters, and only five negative months, since 1996. Peers in the equity market neutral investment strategy Madoff's funds pursued, lost money in six months just last year.

The report said the "small steady consistent returns" Madoff claimed to make did not match his investment strategy, which would fall when markets fell.

Madoff bought shares in about 50 large US firms whose performance he expected to resemble the S&P 100 share index's, while trading in options based on that index. The derivatives would limit losses, but also cap profits, from his funds. Anticipated appreciation in the shares' prices would drive returns. However, Infovest found the open interest in put options based on the S&P 100 index, which Madoff claimed to use, was too small to construct the hedges for his share portfolio as described in marketing information for funds that fed into Madoff's products.

Infovest said: "It is implausible that the S&P options markets that Madoff said he traded could be the size of the combined feeder fund assets, which are estimated at $13bn (€9.5bn). Only about $3.25bn of stock could have been protected by the total S&P 100 options outstanding at the end of November."

Whistleblower Harry Markopolos told US regulator the Securities & Exchange Commission Madoff's returns over 87 months analysed did not resemble those of the Gateway Option Income Fund, the one other publicly traded option income fund with a history the length of Madoff’s. Madoff fell in three months while Gateway lost money in 26, generating 10.3% annualised against Madoff's 15.6%.

Despite this the world's largest investors in hedge funds invested. RMF, Man Group's institutional fund management arm did, alongside Swiss bank UBP, London's Bramdean Alternatives, and US investors Fairfield Greenwich and Kingate Management.

UBP, which invested via 11 of its products, told investors after his arrest last month "Madoff’s 'split-strike conversion' strategy offered stable returns with a long and audited track record. The downside to the strategy seemed very limited." The bank also took comfort in extra insight into market dynamics Madoff could be expected to gain from the market making portion of his operations.

Infovest's analysis also noted a surprising lack of large US companies among his largest 15 investments as detailed in US regulatory filings from the third quarter of last year. The $177m revealed by the filings then was "a far cry" from the $17bn he claimed to manage, the researchers said. One London lawyer added: "A number of investors who invested in Madoff on behalf of other people could find themselves exposed to criticism." He added investors caught out could be bound by their fiduciary duty to their clients to pursue recompense through litigation.