Sunday, December 28, 2008

General Misperceptions of “The Madoff Affair”

I had not intended to devote another blog to what the French have called “The Madoff Affair” before securing additional perspective and information. However, recent writings and holiday party discussions have highlighted a lack of understanding about the workings of the investment world. In this context, I offer the following points which have not been covered in the press.

Bernie Madoff entered the brokerage world as a proprietor of an Over-the-Counter dealer in Puts and Calls, one of the first types of derivatives traded beyond the stricter rules of exchange-traded securities. The price spreads between the Bid and Asked at the same strike price (face value) could be quite large, as there was little in the way of competitive bids and offers at the same strike price. Much of the Put & Call business came from retail oriented firms who were incentivized to concentrate their business with one or more dealers by being paid for their order flow. Many of the Put & Call Dealers were attempting to lock in the spread. In order to get more people involved, dealers sold combinations of Puts and Calls, either in or out of the money. (Meaning at least one side of the trade approached profitability if it were not for the premium paid for the option.) If you find this description a bit hard to follow, so did the regulators, leading this portion of the market to be aptly described as the “Wild West.” Regulators did not have the appropriate tools or business knowledge to oversee Madoff’s activities.

Bernie learned his trade well. With the founding of the Chicago Board of Options Exchange (CBOE), the game changed as spreads narrowed and trades were recorded for all to see. Bernie adapted quite well. He used the payment for order flow approach plus a significant investment in some of the faster computer software and hardware available to earn a significant share in all principal markets in the country. Some people thought he substituted his own capital through the use of options to offset imbalances. If there was any such activity, I believe now, it was the use of his investment firms' orders that had the advantage.

Madoff created two separate firms according to function. The first and by far the largest in terms of employees and image was the old Put & Call firm, which was one of the country’s largest brokerage firms, trading a large share of orders, probably not volume. One of the key benefits of this arrangement was that the brokerage firm could act as a custodian for customer securities. Most investors are familiar receiving monthly account statements, though only recently have these reports included performance calculations. Many smaller, non-publicly owned brokers like Madoff, are only audited once a year, conducted by less prominent accounting firms, and publishing only a statement of financial condition, not a profit and loss statement. Except by sampling, individual accounts are not reviewed.

The second firm that Bernie Madoff created was a registered investment adviser. This was a very unusual firm in that it did not charge for its services. The given reason was that the combination of the firms would make its profits from the trading in the brokerage firm. (Perhaps this distinction may play a role in their legal defense. The courts will have to decide whether the investment firm actually gave advice to these brokerage accounts.

Apparently most of the money that was “managed” came in through what is called “feeder funds.” Feeder funds are a common way for hedge funds and offshore funds to receive capital indirectly. There has not been enough disclosure as to what multiple functions these feeder funds supposedly provided to Madoff. The range of possibilities include some or all of the following: (a) an introducer to a disclosed adviser or fund, (b) a purported fund of funds with only one sub-fund, or (c) a bank or brokerage firm providing leverage at the fund or account level. It will be the jurisdiction of the various regulators or courts to determine what functions were actually offered or performed, and who had what level of knowledge regarding fraud.

Undoubtedly the biggest misperception was that the investments could regularly produce, with very rare deviations or losses, a predictably performing vehicle capable of producing higher returns than bonds with less volatility than stocks. In the aftermath of the Tech Bubble, and the more recent liquidity/credit collapse, investors felt comfortable, indeed conservative, putting so much of their wealth into this wonder. How could they be wrong when so many of the most respected people and organizations in their world also invested knowingly in Bernie Madoff’s wonderful money maker?

Not enough time has passed and the disclosure has been too limited to draw conclusive lessons from this great tragedy. Two lessons are of paramount importance: First, that diversification should be an absolute requirement for all portfolios, particularly institutional accounts. Second, one should search for investment advisers who have disclosed skills and a history of competitive investing.

I am currently in the process of helping a non-profit organization who has been hurt in this affair.

Sunday, December 21, 2008

Correlations: Useful, Labels: Misleading.

One of the characteristics of an equity Bear Market is everything goes down. Mathematically this phenomenon is described as the narrowing of correlations. In other words, almost every stock goes down about the same amount.

Because I am comfortable reviewing the performance of over 16,000 funds each week, in some regards I have a distinct advantage when developing investment policy. As an example, you might find the following method useful in developing your own investment strategy.

Most people look exclusively at the best fund in its class or at least the average performer. I take a very different approach when using fund classification as a tool for fund selection.

In this case I looked at the second worst performing fund in major so-called asset allocation buckets, broken down by investment objectives, using the 52 week period ending December 11, 2008. (I will be happy to discuss with anyone the benefits of excluding extreme examples.)

Key: (G) = growth, (C) = core, (V) = value

Second worst among Large Capitalization funds:
(G) - 60.22%
(C) - 55.58%
(V) - 52.27%

Second worst among Mid-Cap funds:
(G) -61.47%
(C) -58.88%
(V) -57.48%

Second worst among Small Cap funds:
(G) -61.52%
(C) -62.94% *
(V) -59.68%
* In the case of Small Cap Core funds, I used the fourth worst fund as the others had more derivatives in the portfolio.

Second worst among International Large Cap funds:
(G) -56.13%
(C) -54.26%
(V) -53.97%


1. Note the narrow performance correlation of these funds
2. Poor performance ranged between -52.27% and -62.94% compared to the average S&P 500 index fund of -40.21
3. International diversification in large caps did not help.
4. Slightly smaller losses were experienced in value oriented funds.
5. One can be exposed to losing half of one’s investment in many places.

Similar exercises can produce the same relative results when applied to most securities indexes.

In this “sound bite” world it is important to recognize that various labels, e.g. stock market, blue chip, growth and value, are not particularly useful in the selection process.

Please let me know if I should plan to write about selection criteria and due diligence in future blogs.

Monday, December 15, 2008

Round Peg in Square Hole Produces Splinters

After a shocked weekend dealing with what the French will call “The Madoff Affair,” Sunday night finds me thinking about the lessons that have been forgotten. First and foremost, is the lesson that unbelievably good results do not overcome the need for due diligence. The appropriate outlook is the one that cautious investors have relied on since the beginning of handing one’s own money to another: Unbelievably good results ARE unbelievable. Part of the unquenchable belief is imbedded in the alchemy of academics, confusing volatility with risk. In my book MONEY WISE, I try to focus readers’ attention on the real meaning of risk. The real meaning of risk is the large, permanent loss of assets that can change one’s ability to meet life’s goals. In the Madoff case, investors experienced few fluctuations in their consistently high monthly returns. With little or no volatility, the resulting returns produced unbelievably high risk-adjusted returns. We have seen this action occur previously, right before the last Act’s denouement.

Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.

The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.

With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.

P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.

Sunday, December 7, 2008

"Four Aspects of a Four-Letter Word"

In MONEY WISE, I wrote a chapter on risk, emphasizing the four root causes for investments turning out badly: Overconfidence, Personality Change, Leverage and Unanticipated Events. Each of these contributed to the loss of capital in 2008.

In late 2007 and early 2008, many recognized that there were storm clouds on the horizon. The problems looked to be excesses on the top of reasonably sound fundamentals. Historically, the general market on average over a ten year period has two declines of over 10%; with the largest decline being less than 25%. Furthermore, history indicates that once in a generation a decline of 50% occurs.

Using this history as a guide, like many analysts I was concerned, but not ready to materially change investment portfolios. Many of us believed we would have a decline followed by a rigorous recovery. Under those circumstances the prescription to avoiding being too smart was to buy and hold relatively high quality securities.

One year later in the fall of 2008 we see a much different landscape. What went wrong?

The first risk ingredient I discussed in MONEY WISE was Overconfidence. Many professionals erroneously thought that experiencing market declines for forty or fifty years would qualify as the complete relevant market experience. Many, myself included, felt that while age does not equate with wisdom, it helps.

Because there had not been a fixed-income led stock market crash since the Great Depression, many of us “equity guys” missed it. Having grown up in the financial services industry, and in many cases on a first-name basis with the CEOs of major firms, I was able to see that most were honest and hard-working leaders with their own fortunes tied up in their companies – thus they were poised to do the right thing. We were all over-confident.

Personality change is another source of risk. (Normally the most prevalent personality change risk is that of the investor, investment committee or key manager.) As the operating baton of management was turned over from experienced, known individuals to younger management, it was logical to assume that they were being replaced in-kind. In many cases, this proved not to be the case as the new leaders wanted to prove that they were better than those they replaced. Some expanded their product and geographical ranges beyond the old footprint. Often the expansions were in products that were unfamiliar to the new leaders, their control mechanisms, and the bulk of their middle management. Thus a change in managers was also a marked “Personality Change.”

Another “Personality Change” of note occurred during this presidential election cycle. Many thought that there would be a continuation of the present policies, perhaps slowed by a bulky Congress. As the campaign progressed however, investors became concerned about comments packaged for the fringe elements on each side. Fortunately the new Administration sounds as if it will be vigorously centrist.

Much has been written about leveraging and deleveraging, but little has focused on the benefit of being correct or wrong about future price trends. In the period of the five years ending in 2006, those using financial leverage have been winners and in many case big winners. The reverse became more evident in late ’07, and made public when their financial statements were published earlier this year.

Much less has been written about operating leverage. Operating leverage occurs when revenues exceed or contract relative to a fixed cost break-even point. During periods of high sales growth, operating leverage produces significantly higher earnings growth than sales growth. Operating leverage is extremely important in high fixed-cost manufacturing industries.

Over the past year, even with the rapid expansion of consumer demand in the major developing countries, world unit growth began to fall. The result was depressed operating leverage and diminished earnings and stock-prices. Ironically, in this case a lack of leverage (operating) contributed to the problem.

The final cause of risk discussed in MONEY WISE is the risk of unanticipated events. In my own case, I recognized many of the structural weaknesses in the financial community, but because they had been there for years, I never expected that they would all arrive at their comeuppance at the same time. We all missed the greater, global, significance of the increasing failure rate in subprime mortgages. The interconnections between the equity markets and fixed-income derivatives were theoretical to many, and the possibility of a simultaneous collision of these forces posed an extreme example of an unanticipated event.

Each of these four aspects of risk and their appearance in 2008 provide valuable lessons for all investors. In the future I hope to use this space to write about understanding additional aspects of risk when building long-term portfolio strategy.

I welcome your own thoughts and your personal risk avoidance strategies.