Recount how Bernie Madoff's hedge fund came about and outline the strategy it claimed to follow and the performance it reported.
The idea
Bernard Madoff founded a broker-dealer in 1960 that grew into one of the largest market makers on Wall Street, and he became a prominent industry figure, including a stint as chairman of NASDAQ. Alongside the market-making business sat an investment advisory operation, run in secrecy, that managed money for wealthy individuals and, later, for large feeder funds. The claimed strategy was the split-strike conversion. The fund said it held a basket of large S&P 100 stocks, sold out-of-the-money calls against it and bought out-of-the-money puts, which is a collar, and moved to Treasury bills at times. Reported returns were steady, roughly 10 to 12 percent a year with very few losing months, in bull and bear markets alike. In truth it was a Ponzi scheme paying redemptions from new deposits. Remember the claimed strategy caps both gains and losses, so smooth returns look plausible until you test them.
A practice question
Which description best fits how the Madoff investment fund came about?
- It was carved out of a large bank's proprietary trading desk after a decade of internal trading and was then offered to outside investors through a registered mutual fund.Why not: Confuses the fund with a bank spin-off; Madoff's firm was an independent broker-dealer, not a bank desk.
- It grew out of a broker-dealer and market-making firm founded by Bernard Madoff in 1960, with an investment advisory operation running alongside it. - correct
- It was launched as a fund of funds by a group of institutional allocators who hired Madoff only as an execution broker.Why not: Reverses the roles: the advisory business was Madoff's own, and feeder funds later fed money to him.
- It began as a venture capital partnership that gradually shifted into listed equity options in the 1990s.Why not: Invents a venture capital origin; there was no such history, the business came from market making.
The Madoff advisory business grew inside Bernard L. Madoff Investment Securities, a broker-dealer and market maker founded in 1960. It was not a bank spin-off, a fund of funds started by allocators, or a venture vehicle.
A harder one
A due diligence analyst models the claimed strategy for one month. The basket is bought at 100, a call struck at 105 is sold for 2.0 and a put struck at 95 is bought for 1.5, all per 100 of stock and ignoring dividends and financing. The largest one-month gain the position can deliver is closest to:
- 5.5 - correct
- 5.0Why not: Ignores the net premium received; the 0.5 net credit adds to the gain.
- 7.0Why not: Adds the call premium of 2.0 but forgets that the put premium of 1.5 was paid.
- 4.5Why not: Subtracts the net credit from the cap instead of adding it, which is the maximum loss figure, not the gain.
Maximum gain occurs at or above 105: stock gain 5 plus net premium (2.0 received minus 1.5 paid = 0.5 credit) = 5.5. The collar caps the upside, which is why steady double-digit returns should have raised questions.
The hardest tier
A feeder fund reports eleven monthly returns of +1.3 percent and one of -0.9 percent over a year, similar to the Madoff track record. The compound annual return is closest to:
- 13.4%Why not: Adds the twelve monthly returns arithmetically, ignoring compounding.
- 14.2% - correct
- 16.8%Why not: Compounds 1.3 percent twelve times, leaving out the losing month.
- 15.6%Why not: Multiplies 1.3 percent by twelve, treating every month as a gain and ignoring compounding.
Compound growth = 1.013^11 x 0.991 - 1 = 14.2 percent. Summing gives 13.4, 12 x 1.3 gives 15.6, and omitting the loss and compounding gives 16.8. Smooth series such as this, with one small loss, were the signature of the reported record.
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