5. The third party hedge funds and fund of funds that market this hedge fund strategy that invests in BM don’t name and aren’t allowed to name Bernie Madoff as the actual manager in their performance summaries or marketing literature. Look closely at Attachment 1, Fairfield Sentry Ltd.’s performance summary and you won’t see BM’s name anywhere on the document, yet BM is the actual hedge fund manager with discretionary trading authority over all funds, as agent.
Red Flag # 3: Why the need for such secrecy?If I was the world’s largest hedge fund and had great returns, I’d want all the publicity I could garner and would want to appear as the world’s largest hedge fund in all of the industry rankings. Name one mutual fund company, Venture Capital firm, or LBO firm which doesn’t brag about the size of their largest funds’ assets under management. Then ask yourself, why would the world’s largest hedge fund manager be so secretive that he didn’t even want his investors to know he was managing their money? Or is it that BM doesn’t want the SEC and FSA to know that he exists?
6. The third party FOF’s never tell investors who is actually managing their money and describe the investment strategy as: This hedge fund’s objective is long term growth on a consistent basis with low volatility. The investment advisor invests exclusively in the U.S. and utilizes a strategy often referred to as a “split-strike conversion.” Generally this style involves purchasing a basket of 30-35 large-capitalization stocks with a high degree of correlation to the general market (e.g. American Express, Boeing, Citigroup, Coca-Cola, Dupont, Exxon, General Motors, IBM, Merck, McDonalds). To provide the desired hedge, the manager then sells out-of-the-money OEX index call options and buys out-of-the-money OEX index put options. The amount of calls that are sold and puts that are bought represent a dollar amount equal to the basket of shares purchases.
7. I personally have run split-strike conversion strategies and know that BM’s approach is far riskier than stated in 6 above. His strategy is wholly inferior to an all index approach and is wholly incapable of generating returns in the range of 6.23% to 19.98%. BM’s strategy should not be able to beat the return on US Treasury Bills. Due to the glaring weakness of the strategy: A. Income Part of the strategy is to buy 30-35 large-cap stocks, sell out-of-the-money index call options against the value of the stock basket. There are three possible sources of income in this strategy.1. We earn income from the stock’s dividends. Let’s attribute a 2% average return to this source of funds for the 14½ year time period. This explains 2% of the 16% average gross annual returns before fees and leaves 14% of the returns unexplained.
2. We earn income from the sale of OTC OEX index call options. Let’s also assume that we can generate an additional 2% annual return via the sale of OTC out-of-the-money OEX index call options which leaves 12% of the 16% gross returns unexplained. On Friday, October 14, 2005 the OEX (S&P 100) index closed at 550.49 and there were only 163,809 OEX index call option contracts outstanding (termed the “open interest”). 163,809 call option calls outstanding x $100 contact multiplier x 550.49 index closing price = $9,017,521,641 in stock equivalents hedged.
3. We can earn income from capital gains by selling the stocks that go up in price. This portion of the return stream would have to earn the lion’s share of the hedge fund strategy’s returns. We have 12% of the return stream unexplained so far. However, the OTC OEX index puts that we buy will cost AT LEAST <8%> per year (a lot more in most years but I’m giving BM the benefit of every doubt here). Therefore, BM’s stock selection would have to be earning an average of 20% per year. That would mean that he’s been the world’s best stock-picker since 1990 beating out such luminaries as Warren Buffet and Bill Miller. Yet no one’s ever heard of BM as being a stock-picker, much less the world’s best stock-picker. Why isn’t he famous if he was able to earn 20% average annual returns?
Red Flag # 4: $9.017 billion in total OEX listed call options outstanding is not nearly enough to generate income on BM’s total amount of assets under management which I estimate to range between $20-$50 billion. Fairfield Sentry Ltd. alone has $5.1 billion with BM. And, while BM may say he only uses Over-the-Counter (OTC) index options, there is no way that this is possible. The OTC market should never be several times larger than the exchange listed market for this type of plain vanilla derivative.
B. Protection Part of the strategy is to buy out-of-the-money OEX index put options. This costs you money each and every month. This hurts your returns and is the main reason why BM’s strategy would have trouble earning 0% average annual returns much less the 12% net returns stated in Fairfield Sentry Ltd.’s performance summary. Even if BM earns a 4% return from the combination of 2% stock dividends and 2% from the sale of call options, the cost of the puts would put this strategy in the red year in and year out. No way he can possibly be delivering 12% net to investors. The math just doesn’t support this strategy if he’s really buying index put options.
Red Flag # 5: BM would need to be purchasing at-the-money put options because he has only 7 small monthly losses in the past 14½ years. His largest monthly loss is only <0.55%>, so his puts would have to be at-the-money. At-the-money put options are very, very expensive. A one-year at-the-money put option would cost you <8%> or more, depending upon the market’s volatility. And <8%> would be a cheap price to pay in many of the past 14½ years for put protection!! Assuming BM only paid <8%> per year in put protection, and assuming he can earn +2% from stock dividends plus another +2% from call option sales, he’s still under-water <4%> performance wise. <8%> put cost + 2% stock dividends + 2% income from call sales = <4%>. And, I’ve proven that BM would need to be earning at least 16% annually to deliver 12% after fees to investors. That means the rest of his returns would have to be coming from stock selection where he picked and sold winning stocks to include in his 35-stock basket of large-cap names. Lots of luck doing that during the past stock market crises like 1997’s Asian Currency Crises, the 1998 Russian Debt / LTCM crises, and the 2000-2002 killer bear market. And index put option protection was a lot more expensive during these crises periods than 8%. Mathematically none of BM’s returns listed in Attachment 1 make much sense. They are just too unbelievably good to be true.
C. The OEX index (S&P 100) closed at 550.49 on Friday, October 14, 2005 meaning that each put option hedged $55,049 dollars worth of stock ($100 contract multiplier x 550.49 OEX closing index price = $55,049 in stock hedged). As of that same date, the total open interest for OEX index put options was 307,176 contracts meaning that a total of $16,909,731,624 in stock was being hedged by the use of OEX index puts (307,176 total put contracts in existence as of Oct 14th x $55,049 hedge value of 1 OEX index put = $16,909,731,624 in stock hedged). Note: I excluded a few thousand OEX LEAP index put options from my calculations because these are long-term options and not relevant for a split-strike conversion strategy such as BM’s.
Red Flag # 6: At my best guess level of BM’s assets under management of $30 billion, or even at my low end estimate of $20 billion in assets under management, BM would have to be over 100% of the total OEX put option contract open interest in order to hedge his stock holdings as depicted in the third party hedge funds marketing literature. In other words, there are not enough index option put contracts in existence to hedge the way BM says he is hedging! And there is no way the OTC market is bigger than the exchange listed market for plain vanilla S&P 100 index put options.
D. Mathematically I have proven that BM cannot be hedging using listed index put and call options. One hedge fund FOF has told me that BM uses only Over-the-Counter options and trades exclusively thru UBS and Merrill Lynch. I have not called those two firms to check on this because it seems implausible that a BD would trade $20 - $50 billion worth of index put options per month over-the-counter thru only 2 firms. That plus the fact that if BM was really buying OTC index put options, then there is no way his average annual returns could be positive !! At a minimum, using the cheapest way to buy puts would cost a fund <8%> per year. To get the put cost down
to <8%>, BM would have to buy a one-year at-the-money put option and hold it for one-year. No way his call sales could ever hope to come even fractionally close to covering the cost of the puts.
Red Flag # 7: The counter-party credit exposures for UBS and Merrill would be too large for these firms credit departments to approve. The SEC should ask BM for trade tickets showing he has traded OTC options thru these two firms. Then the SEC should visit the firms’ OTC derivatives desks, talk the to heads of trading and ask to see BM’s trade tickets. Then ask the director of operations to verify the tickets and ask to see the inventory of all of the stock and listed options hedging the OTC puts and calls. If these firms can’t show you the off setting hedged positions then they are assisting BM as part of a conspiracy to commit fraud. If any other brokerage firms equity derivatives desk is engaged in a conspiracy to cover for BM, then this scandal will be a doozy when it hits the financial press but at least investors would have firms with deep pockets to sue.
Red Flag # 8: OTC options are more expensive to trade than listed options. You have to pay extra for the customization features and secrecy offered by OTC options. Trading in the size of $20-$50 billion per month would be impossible and the bid-ask spreads would be so wide as to preclude earning any profit whatsoever. These BrokerlDealers would need to offset their short OTC index put option exposure to a falling stock market by hedging out their short put option risk by either buying listed put options or selling short index futures and the derivatives markets are not deep and liquid enough to accomplish this without paying a penalty in prohibitively expensive transaction costs.
Red Flag # 9: Extensive and voluminous paperwork would be required to keep track of and clear each OTC trade. Plus, why aren’t Goldman, Sachs and Citigroup involved in handling BM’s order flow? Both Goldman and Citigroup are a lot larger in the OTC derivatives markets than UBS or Merrill Lynch.
E. My experience with split-strike conversion trades is that the best a good manager is likely to obtain using the strategy marketed by the third-party FOF’s is T-bills less management fees. And, if the stock market is down by more than 2%, the return from this strategy will range from a high of zero return to a low of a few percent depending upon your put’s cost and how far out-of-the-money it is.
F. In 2000 I ran a regression of BM’s hedge fund returns using the performance data from Fairfield Sentry Limited. BM had a .06 correlation to the equity market’s return which confirms the .06 Beta that Fairfield Sentry Limited lists in its return numbers.
Red Flag # 10: It is mathematically impossible for a strategy using index call options and index put options to have such a low correlation to the market where its returns are supposedly being generated from. This makes no sense! The strategy depicted retains 100% of the single-stock downside risk since they own only index put options and not single stock put options. Therefore if one or more stocks in their portfolio were to tank on bad news, BM’s index put would offer little protection and their portfolio should feel the pain. However, BM’s performance numbers show only 7 extremely small losses during 14½ years and these numbers are too good to be true. The largest one month loss was only - 55 basis points (-0.55%) or just over one-half of one percent! And BM never had more than a one month losing streak! Either BM is the world’s best stock and options manager that the SEC and the investing public has never heard of or he’s a fraud. You would have to figure that at some point BM owned a WorldCom, Enron, GM or HealthSouth in their portfolio when bad or really bad news came out and caused these stocks to drop like a rock.
8. Red Flag # 11: Two press articles, which came to print well after my initial May 1999 presentation to the SEC, do doubt Bernie Madoff’s returns and they are: a. The May 7, 2001 edition of Barron’s, in an article entitled, “Don’t Ask, Don’t Tell; Bernie Madoff is so secretetive, he even asks his investors to keep mum,” written by Erin Arvedlund, published an expose about Bernie Madoff a few years ago with no resulting investigation by any regulators. Ms. Arvedlund has since left Barron’s. I have attached a copy of the Barrons’ article which lists numerous red flags.
b. Michael Ocrant, formerly a reporter for MARHedge visited Bernie Madoff’s offices and wrote a very negative article entitled, “Madoff tops charts; skeptics ask how,” that doubted the source of BM’s returns. This article was published on May 1, 2001 and is attached [see Appendix A of this book]. Mr. Ocrant has graciously agreed to cooperate fully with the SEC and awaits the SEC’s telephone call to arrange a meeting. The SEC should contact him directly. Michael Ocrant is currently serving as the Director of Alternative Investments; Institutional Investor; New York, NY 10001; Telephone #orEmail:
9. Fund of funds with whom I have spoken to that have BM in their stable of funds continually brag about their returns and how they are generated thanks to BM’s access to his broker-dealer’s access to order flow. They believe that BM has perfect knowledge of the market’s direction due to his access to customer order flow into his broker-dealer.
Red Flag # 12: Yes, BM has access to his customer’s order flow thru his broker-dealer but he is only one broker out of many, so it is impossible for him to know the market’s direction to such a degree as to only post monthly losses once every couple of years. All of Wall Street’s big wire houses experience trading losses on a more regular frequency that BM. Ask yourself how BM’s trading experience could be so much better than all of the other firms on Wall Street. Either he’s the best trading firm on the street and rarely ever has large losing months unlike other firms or he’s a fraud.
10. Red Flag # 13: I believe that BM’s returns can be real ONLY if they are generated from front-running his customer’s order flow. In other words, yes, if he’s buying at a penny above his customer’s buy orders, he can only lose one penny if the stock drops but can make several pennies if the stock goes up. For example, if a customer has an order to buy 100,000 shares of IBM at $100, BM can put in his own order to buy 100,000 shares of IBM at $100.01. This is what’s known as a right-tail distribution and is very similar to the payoff distribution of a call option. Doing this could easily generate returns of 30%-60% or more per anum. He could be doing the same thing by front-running customer sell orders. However, if BM’s returns are real but he’s generating them from front-running there are two problems with this: a. Problem # 1: front-running is one form of insider-trading and is illegal.
b. Problem # 2: generating real returns from front-running but telling hedge fund investors that you are generating the returns via a complex (but unworkable) stock and options strategy is securities fraud.
Some time ago, during different market conditions, I ran a study using the Black-Scholes Option Pricing Model to analyze the value of front-running with the goal of putting a monetary value on front-running where the insider knew the customer’s order and traded ahead of it. When I ran the study the model inputs were valued at: OEX component stocks annualized volatility on a cap-weighted basis was 50% (during a bear market period), the T-bill rate was 5.80%, and the average stock price was $46. I then calculated the value of an at-the-money call options over time intervals of 1 minute, 5 minutes, 10 minutes, and 15 minutes. I used a 253 trading day year. The SEC should be able to duplicate these results:1 minute option = 3 cents worth of trade information value
5 minute option = 7 cents worth of trade information value
10 minute option = 10 cents worth of trade information value
15 minute option = 12 cents worth of trade information value
Conclusion: Bernie Madoff used to advertise in industry trade publications that he would pay 1 cent per share for other broker’s order flow. If he was paying 1 cent per share for order flow and front-running these broker’s customers, then he could easily be earning returns in the 30%-60% or higher annually. In all time intervals ranging from 1 minute to 15 minutes, having access to order flow is the monetary equivalent of owning a valuable call option on that order. The value of these implicit call options ranges between 3 - 12 times the one penny
per share paid for access to order flow. If this is what he’s doing, then the returns are real but the stated investment strategy is illegal and based solely on insider-trading.
NOTE: I am pretty confident that BM is a Ponzi Scheme, but in the off chance he is front-running customer orders and his returns are real, then this case qualifies as insider-trading under the SEC’s bounty program as outlined in Section 21A(e) of the 1934 Act. However, if BM was front-running, a highly profitable activity, then he wouldn’t need to borrow funds from investors at 16% implied interest. Therefore it is far more likely that BM is a Ponzi Scheme. Front-running is a very simple fraud to commit and requires only access to inside information. The elaborateness of BM’s fund-raising, his need for secrecy, his high 16% average cost of funds, and reliance on a derivatives investment scheme that few investors (or regulators) would be capable of comprehending lead to a weight of the evidence conclusion that this is a Ponzi Scheme.
11. Red Flag # 14: Madoff subsidizes down months! Hard to believe (and I don’t believe this) but I’ve heard two FOF’s tell me that they don’t believe Madoff can make money in big down months either. They tell me that Madoff “subsidizes” their investors in down months, so that they will be able to show a low volatility of returns. These types of stories are commonly found around Ponzi Schemes. These investors tell me that Madoff only books winning tickets in their accounts and “eats the losses” during months when the market sells off hard. The problem with this is that it’s securities fraud to misstate either returns or the volatility of those returns. These FOF professionals who heard BM tell them that he subsidizes losses were professionally negligent in not turning BM into the SEC, FSA and other regulators for securities fraud.
No One Would Listen: A True Financial Thriller Page 38