Madoff, Warning Signs, and Split Strike Conversions.

Recent News Emphasizes Importance of Due-Diligence

Over the past few days, you have obviously been reading of the Madoff case.  It is stunning to hear of the impact and how far-reaching this situation has become.  From all indications, Madoff was a "stand up guy" that everyone implicitly trusted.  His assets under management and roster of investors would never give anyone the slightest clue that he might be up to no good.  But to everyone's surprise, he was in fact no good - in fact he's a fraud. 

Its this kind of situation that usually gets investors to reconsider the importance of due-diligence.  Not only should investors have a sound understanding of a money management firm's business model but also make sure that all the firms operating activities make sense.  Always keep your eyes open for "warning signs." 

With that said, I want to take this time to discuss three "warning signs" that can sometime pop up when dealing with a hedge fund money manager:

1.  Madoff's feeder funds marketed a "Split Strike Conversion" strategy. 

Lesson:  Make sure you understand the basic premise of the trader's strategy.  Understand that I am not saying that complex models are bad...but rather, if it is complex, make sure that you can generally explain the money-making tools.  Are they a long-only shop?  Do they trade S&P futures?  Or is some type of statistical arbitrage system? 

Bottom line:  If you hear the words "black box" and/or "proprietary" too much then ask more questions. (By the way, nothing drives me crazier than hearing managers using the word "black box" to describe their techniques.  Its overly-generic and way overused these days.)

2. Madoff not only managed client assets but initiated trades in client accounts, executed the trades, custodied those assets, constructed his own client statements and administered the paperwork.  There were no other parties involved - this is a clear red-flag!

Lesson:  Unless you are dealing with a Goldman or UBS size firm, then for the most part, it is a good idea to separate your trading manager from the custodial services.  Ensuring a strict segregation between these two functions can go a long way towards deterring any wrongdoing.   

3.  At the end of every quarter, Madoff's 13F filing showed very little in the way of equity holdings.  And when questioned as to why, their response" "...we go into cash at the end of every quarter..."

Lesson:  I can see this happening every now and then, but to have your hedge fund go into cash at the end of every quarter doesn't sound very efficient.  If your hedge fund has to file a 13F always spend time reviewing it once it is filed.


What is the Split Strike Conversion strategy?  

In the past few days, I have also had a number of clients ask me to explain to them the "Split Strike Conversion" strategy that Madoff marketed to his investors.

Split Strike Conversion defined:

Typically, the strategy consists of the simultaneous ownership of 30-35 S&P 100 stocks, the sale of out-of-the-money calls on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio’s downside. The strategy creates a boundary on a stock or basket of stocks, limiting its upside while at the same time protecting against a sharp price decline.

Long story short:  Put a collar around a basket of S&P 100 stocks.

A fair number of institutional managers long questioned how Madoff could pull off such consistent risk-adjusted returns.  I guess when it seems too good to be true then it probably is. 

Comments

[Alan]

Thanks for the one-line definition on Split Strike Conversion. Just imagine that if the stock market hadn't gone down so much, he could have continued for years before being caught, if ever.

[Agustin gonzalez]

Thanks for the comment. And, yes, the market downturn forced Madoff to show his hand. Did he think he would really get away with it? Amazes me.