Bernie Madoff, Confidence Destroyer

A large number of fund-of-funds firms and other advisory shops are crowing these days about how they looked at Madoff, saw red flags, and didn’t invest. But the fact is that every fund manager who is looked at by

fund-of-funds firms and other advisory shops gets turned down by the overwhelming majority of them. There are lots of funds to choose from, after all.

So I don’t believe that anybody deserves any special props or praise for not investing with Bernie Madoff. Otherwise substantially all of us would be praiseworthy for that reason. Different types of funds appeal to different types of people, and most advisors would turn down Bernie even if he was entirely legitimate.

Which, by the way, is entirely possible. Much as I love the concept of "kleptokurtosis", you can’t simply look at Madoff’s astonishingly regular returns and conclude that he was stealing money. In fact, it’s quite easy to replicate those returns entirely legitimately.

Here’s how you do it: You take the money that people invest with you, and you put it all in Treasury bills. Then you write short-dated deep-out-of-the-money put options on broad stock-market indices. If the stocks move against you, no problem, you’ve got lots of Treasuries to put up as your margin calls increase. But so long as those put options never go into the money, you never actually lose a penny.

Then, every month, once you’ve made 1% of your AUM (or even less, once you consider that your T-bills are paying interest too), you just stop — and go back into 100% Treasuries until the beginning of the next month, when you start all over again.

This strategy works great in up markets and even in the kind of down markets where stocks fall gradually. And then it blows up when there’s a big stock-market plunge, like we saw in October.

Maybe this is more or less what Madoff was doing, until at some point (the bursting of the dot-com bubble, perhaps) he lost lots of money and decided to go Ponzi.

But the fact is that lots of hedge funds blow up, including large ones where there was no illegal activity, like LTCM. LTCM lost billions of its investors’ dollars too — and posed a much greater systemic risk in doing so than Madoff ever did.

So if you’re an investor, yes, you should be worried about losing your money to fraud — but you should also be even more worried about losing it the old-fashioned way, by investing it with a hedge fund manager who blows up spectacularly.

If Madoff is causing a crisis of confidence in the markets, it might be for this reason: that he’s driven home the fact that you can never know for sure that your money is safe and that it will be there tomorrow. That’s always a good reason not to invest in hedge funds, even when fraud isn’t a problem at all. And it’s a problem which even the most perspicacious fund-of-fund manager can’t get around.

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