How to spot Ponzi schemes

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Firms Involved

  • Bernard L. Madoff Investment Securities

Year of the event

2008

Description of the case

Bernard Madoff set up a sort of hedge funds around 1990. His official strategy was a split-strike conversion, which is a combination of a protective put and a covered call. To be more precise, it consists in building a long portfolio, and then sell out-of-the-money calls on an index with which the portfolio is highly correlated, and buying out-of-the-money put options (Strike below the calls'). The fund delivered about 16% annual return with minimal volatility, allowing the feeders such as Fairfield Sentry to reach Sharpe ratios above 2, unusually high for hedge funds. The fund was basically delivering the S&P500 with half its volatility.

However, the scheme proved to be a fraud in the form of a Ponzi Scheme. A rigorous operational due diligence would have raised the following warnings[1] :

  • Madoff's service providers (broker-dealer, fund administration, custody, etc.) were related to Madoff, or the services were performed internally.
  • Madoff's family members occupied key position throughout the structure: board, executive positions, etc.
  • The structure of the fund was complex and obstructed transparency: Madoff's firm was shielded by feeders which portfolios he managed as an advisor.
  • The fee structure was highly unusual: Madoff allegedly only applied transactions fees, and no management nor performance fees.
  • The auditor was an obscure firm which officially declared not having any audit clients, hence avoiding supervision by the regulatory bodies.

In addition, skeptics also highlighted before Madoff's fall that he could not deliver the performance disclosed without front-running the clients of his broker-dealer firm, the other possibility being that he was heading a Ponzi Scheme [2]

Take-aways

  • It is key to perform a rigorous operational due diligence in addition to quantitative analysis in any investment decisions, particularly in hedge funds. Effective frameworks do exist[3].
  • One must always remain skeptical and make sure to understand where the performance of any fund manager comes from. It may be selection skill, market timing skill, luck, fraud, or a mix of those.

References

  1. Gregoriou & L'Habitant, "Madoff: A Riot of Red Flags", 2009
  2. Markopolos, "The World's Largest Hedge Fund is a Fraud", 2005.
  3. Brown, Goetzmann, Liang and Schwarz, "Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration", 2006