In the current bearish environment, when some market experts think the fund should have been showing negative returns, albeit at levels below the benchmark index, managing the strategy has become more difficult, says Madoff, although performance has remained positive or, as in February, flat.
The worst market to operate in using the strategy, he adds, would be a protracted bear market or “a flat, dull market.” In a stock market environment similar to what was experienced in the 1970s, for instance, the strategy would be lucky to return “T-bill like returns.”
Market timing and stock picking are both important for the strategy to work, and to those who express astonishment at the firm’s ability in those areas, Madoff points to long experience, excellent technology that provides superb and low-cost execution capabilities, good proprietary stock and options pricing models, well-established infrastructure, market making ability and market intelligence derived from the massive amount of order flow it handles each day.
The strategy and trading, he says, are done mostly by signals from a proprietary “black box” system that allows for human intervention to take into account the “gut feel” of the firm’s professionals. “I don’t want to get on an airplane without a pilot in the seat,” says Madoff. “I only trust the autopilot so much.”
As for the specifics of how the firm manages risk and limits the market impact of moving so much capital in and out of positions, Madoff responds first by saying, “I’m not interested in educating the world on our strategy, and I won’t get into the nuances of how we manage risk.” He reiterates the undisputed strengths and advantages the firm’s operations provide that make it possible.
Multiple Stock Baskets
Avoiding market impact by trading the underlying securities, he says, is one of the strategy’s primary goals. This is done by creating a variety of stock baskets, sometimes as many as a dozen, with different weightings that allow positions to be taken or unwound slowly over a one- or two-week period.
Madoff says the baskets comprise the most highly capitalized liquid securities in the market, making the entry and exit strategies easier to manage.
He also stresses that the assets used for the strategy are often invested in Treasury securities as the firm waits for specific market opportunities. He won’t reveal how much capital is required to be deployed at any given time to maintain the strategy’s return characteristics, but does say that “the goal is to be 100 percent invested.”
The inability of other firms to duplicate his firm’s success with the strategy, says Madoff, is attributable, again, to its highly regarded operational infrastructure. He notes that one could make the same observation about many businesses, including market making firms.
Many major Wall Street broker-dealers, he observes, previously attempted to replicate established market making operations but gave up trying when they realized how difficult it was to do so successfully, opting instead to acquire them for hefty sums.
[Indeed, says Madoff, the firm itself has received numerous buyout offers but has so far refused any entreaties because he and the many members of his immediate and extended family who work there continue to enjoy what they do and the independence it allows and have no desire to work for someone else.]
Similarly, he adds, another firm could duplicate the strategy in an attempt to get similar results, but its returns would likely be unmatched because “you need the physical plant and a large operation” to do it with equal success. However, many Wall Street firms, he says, do use the strategy in their proprietary trading activities, but they don’t devote more capital to such operations because their return on capital is better used in other operations.
Setting up a proprietary trading operation strictly for the strategy, or a separate asset management division in order to collect the incentive fees, says Madoff, would conflict with his firm’s primary business of market making.
Commissions Suffice
“We’re perfectly happy making the commissions” by trading for the funds, he says, which industry observers note also gives the firm the entirely legitimate opportunity to “piggyback” with proprietary trading that is given an advantage by knowing when and where orders are being placed.
Setting up a division to offer funds directly, says Madoff, is not an attractive proposition simply because he and the firm have no desire to get involved in the administration and marketing required for the effort, nor to deal with investors.
Many parts of the firm’s operations could be similarly leveraged, he notes, but the firm generally believes in concentrating on its core strengths and not overextending itself. Overseeing the capital provided by the funds and its managed accounts, he says, provides another fairly stable stream of revenue that offers some degree of operational diversification.
Madoff readily dismisses speculation concerning the use of the capital as “pseudo equity” to support the firm’s market making activities or provide leverage. He says the firm uses no leverage, and has more than enough capital to support its operations.
He notes that Madoff Securities has virtually no debt and at any given time no more than a few hundred million dollars of inventory.
Since the firm makes markets in only the most highly capitalized, liquid stocks generally represented by the S&P 500 index, a majority of which are listed on the NYSE, as well as the 200 most highly capitalized NASDAQ-listed stocks, says Madoff, it has almost no inventory risk.
Finally, Madoff calls ridiculous the conjecture that the firm at times provides subsidies generated by its market making activities to smooth out the returns of the funds in a symbiotic relationship related to its use of the capital as a debt or equity substitute. He agrees that the firm could easily borrow the money itself at a fairly low interest rate if it were needed, and would therefore have no reason to share its profits.
“Why would we do that?”
Still, when the many expert skeptics were asked by MARHedge to respond to the explanations about the funds, the strategy and the consistently low volatility returns, most continued to express bewilderment and indicated they were still grappling to understand how such results have been achieved for so long.
Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy is the strategy and the returns are the returns.” He suggests that those who believe there is something more to it and are seeking an answer beyond that are wasting their time.
Appendix B
The World’s Largest Hedge Fund Is a Fraud
December 22, 2005 Submission to the SEC Madoff Investment Securities, LLC www.madoff.com
Opening Remarks:
I am the original source for the information presented herein having first presented my rationale, both verbally and in writing, to the SEC’s Boston office in May, 1999 before any public information doubting Madoff Investment Securities, LLC appeared in the press. There was no whistleblower or insider involved in compiling this report. I used the Mosaic Theory to assemble my set of observations. My observations were collected first-hand by listening to fund of fund investors talk about their investments in a hedge fund run by Madoff Investment Securities, LLC, a SEC registered firm. I have also spoken to the heads of various Wall Street equity derivative trading desks and every single one of the senior managers I spoke with told me that Bernie Madoff was a fraud. Of course, no one wants to take undue career risk by sticking their head up and saying the emperor isn’t wearing any clothes but....
I am a derivatives expert and have traded or assisted in the trading of several billion $US in options strategies for hedge funds and institutional clients. I have experience managing split-strike conversion products both using index options and using individual stock options, both with and without index puts. Very few people in the world have the mathematical background needed to manage these types of products but I am one of them. I have outlined a detailed set of Red Flags that make me very suspicious that Bernie Madoff’s returns aren’t real and, if they a
re real, then they would almost certainly have to be generated by front-running customer order flow from the broker-dealer arm of Madoff Investment Securities. LLC.
Due to the sensitive nature of the case I detail below, its dissemination within the SEC must be limited to those with a need to know. The firm involved is located in the New York Region.
As a result of this case, several careers on Wall Street and in Europe will be ruined. Therefore, I have not signed nor put my name on this report. I request that my name not be released to anyone other than the Branch Chief and Team Leader in the New York Region who are assigned to the case, without my express written permission. The fewer people who know who wrote this report the better. I am worried about the personal safety of myself and my family. Under no circumstances is this report or its contents to be shared with any other regulatory body without my express permission. This report has been written solely for the SEC’s internal use.
As far as I know, none of the hedge fund, fund of funds (FOF’s) mentioned in my report are engaged in a conspiracy to commit fraud. I believe they are naive men and women with a notable lack of derivatives expertise and possessing little or no quantitative finance ability.
There are 2 possible scenarios that involve fraud by Madoff Securities: 1. Scenario # 1 (Unlikely): I am submitting this case under Section 21A(e) of the 1934 Act in the event that the broker-dealer and ECN depicted is actually providing the stated returns to investors but is earning those returns by front-running customer order flow. Front-running qualifies as insider-trading since it relies upon material, non-public information that is acted upon for the benefit of one party to the detriment of another party. Section 21A(e) of the 1934 Act allows the SEC to pay up to 10% of the total fines levied for insider-trading. We have obtained approval from the SEC’s Office of General Counsel, the Chairman’s Office, and the bounty program administrator that the SEC is able and willing to pay Section 21A(e) rewards. This case should qualify if insider-trading is involved.
2. Scenario # 2 (Highly likely) Madoff Securities is the world’s largest Ponzi Scheme. In this case there is no SEC reward payment due the whistle-blower so basically I’m turning this case in because it’s the right thing to do. Far better that the SEC is proactive in shutting down a Ponzi Scheme of this size rather than reactive.
Who: The politically powerful Madoff family owns and operates a New York City based broker-dealer, ECN, and what is effectively the world’s largest hedge fund. Bernard “Bernie” Madoff, the family patriarch started the firm.
According to the www.madoff.com website, “Bernard L. Madoff was one of the five broker-dealers most closely involved in developing the NASDAQ Stock Market. He has been chairman of the board of directors of the NASDAQ Stock Market as well as a member of the board of governors of the NASD and a member of numerous NASD committees. Bernard Madoff was also a founding member of the International Securities Clearing Corporation in London.
His brother, Peter B. Madoff has served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He also has been actively involved in the NASDAQ Stock Market as a member of its board of governors and its executive committee and as chairman of its trading committee. He also has been a member of the board of directors of the Security Traders Association of New York. He is a member of the board of directors of the Depository Trust Corporation.
What: 1. The family runs what is effectively the world’s largest hedge fund with estimated assets under management of at least $20 billion to perhaps $50 billion, but no one knows exactly how much money BM is managing. That we have what is effectively the world’s largest hedge fund operating underground is plainly put shocking. But then again, we don’t even know the size of the hedge fund industry so none of this should be surprising. A super-sized fraud of this magnitude was bound to happen given the lack of regulation of these off-shore entities. My best guess is that approximately $30 billion is involved.
2. However the hedge fund isn’t organized as a hedge fund by Bernard Madoff (BM) yet it acts and trades exactly like one. BM allows third party Fund of Funds (FOF’s) to private label hedge funds that provide his firm, Madoff Securities, with equity tranch funding. In return for equity tranch funding, BM runs a trading strategy, as agent, whose returns flow to the third party FOF hedge funds and their investors who put up equity capital to fund BM’s broker-dealer and ECN operations. BM tells investors it earns its fees by charging commissions on all of the trades done in their accounts.
Red Flag # 1: Why would a US broker-dealer organize and fund itself in such an unusual manner? Doesn’t this seem to be an unseemly way of operating under the regulator’s radar screens? Why aren’t the commissions charged fully disclosed to investors? Can a SEC Registered Investment Advisor charge both commissions and charge a principle fee for trades? MOST IMPORTANTLY, why would BM settle for charging only undisclosed commissions when he could earn standard hedge fund fees of 1 % management fee + 20% of the profits? Doing some simple math on BM’s 12% average annual return stream to investors, the hedge fund, before fees, would have to be earning average annual returns of 16%. Subtract out the 1 % management fee and investors are down to 15%. 20% of the profits would amount to 3% (.20 x 15% = 3% profit participation) so investors would be left with the stated 12% annual returns listed in Attachment 1 (Fairfield Sentry Ltd. Performance Data). Total fees to the third party FOF’s would amount to 4% annually. Now why would BM leave 4% in average annual fee revenue on the table unless he were a Ponzi Scheme? Or, is he charging a whole lot more than 4% in undisclosed commissions?
3. The third parties organize the hedge funds and obtain investors but 100% of the money raised is actually managed by Madoff Investment Securities, LLC in a purported hedge fund strategy. The investors that pony up the money don’t know that BM is managing their money. That Madoff is managing the money is purposely kept secret from the investors. Some prominent US based hedge fund, fund of funds, that “invest” in BM in this manner include:a. Fairfield Sentry Limitedwhich had $5.2 billion invested in BM as of May 2005; 11th Floor, 919 Third Avenue; New York, NY 10022; Telephone 212.319.6060; The Fairfield Greenwich Group is a global family of companies with offices in New York, London and Bermuda, and representative offices in the U.S., Europe and Latin America. Local operating entities are authorized or regulated by a variety of government agencies, including Fairfield Greenwich Advisors LLC, a U.S. SEC registered investment adviser, Fairfield Heathcliff Capital LLC, a U.S. NASD member broker-dealer, and Fairfield Greenwich (UK) Limited, authorized and regulated by the Financial Services Authority in the United Kingdom.
b. Access International Advisors ; www.aiagroup.com; a SEC registered investment advisor, telephone # 212.223.7167; Suite 2206; 509 Madison Avenue, New York, NY 10022 which had over $450 million invested with BM as of mid- 2002. The majority of this FOF’s investors are European, even though the firm is US registered.
c. Broyhill All-Weather Fund, L.P. hadmillion invested with BM as of March 2000.
d. Tremont Capital Management, Inc. Corporate Headquarters is located at 555 Theodore Fremd Avenue; Rye, New York 10580; T: (914) 925-1140 F: (914) 921-3499. Tremont oversees on an advisory and fully discretionary basis over $10.5 billion in assets. Clients include institutional investors, public and private pension plans, ERISA plans, university endowments, foundations, and financial institutions, as well as high net worth individuals. Tremont is owned by Oppenhiemer Funds Inc. which is owned by Mass Mutual Insurance Company so they should have sufficient reserves to make investors whole. Mass Mutual is currently under investigation by the Massachusetts Attorney General, the Department of Justice, and the SEC.
e. Kingate Fund run by FIM Advisers LLP is headquartered in London at 20 St. James Street; London SW1A 1ES; telephone # +44 20 7389 8900; fax # +44 20 7389 8911; www.fim-group.com/. However, their US subsidiary, FIM (USA) Inc. is located at 780 Third Avenue; New York, NY 10017; telephone # 212.223.7321 or fax # 212.223.7592.
f.
During a 2002 marketing trip to EuropeFOF I met with in Paris and Geneva had investments with BM. They all said he was their best manager! A partial list of money managers and Private Banks that invest in BM is included at the end of this report in Attachment 3.
4. Here’s what smells bad about the idea of providing equity tranch funding to a US registered broker-dealer:a. The investment returns passed along to the third party hedge funds are equivalent to BM borrowing money. These 12 month returns from 1990 - May 2005 ranged from a low of 6.23% to a high of 19.98%, with an average 12 month return during that time period of 12.00%. Add in the 4% in average annual management & participation fees and BM would have to be delivering average annual returns of 16% in order for the investors to receive 12%. No Broker-Dealer that I’ve ever heard of finances its operations at that high of an implied borrowing rate (source: Attachment 1; Fairfield Sentry Limited return data from December 1990 - May 2005). Ask around and I’m sure you’ll find that BM is the only firm on Wall Street that pays an average of 16% to fund its operations.
b. BD’s typically fund in the short-term credit markets and benchmark a significant part of their overnight funding to LIBOR plus or minus some spread. LIBOR + 40 basis points would seem a more realistic borrowing rate for a broker-dealer of BM’s size.
c. Red Flag # 2: why would a BD choose to fund at such a high implied interest rate when cheaper money is available in the short-term credit markets? One reason that comes to mind is that BM couldn’t stand the due diligence scrutiny of the short-term credit markets. If Charles Ponzi had issued bank notes promising 50% interest on 3 month time deposits instead of issuing unregulated Ponzi Notes to his investors, the State Banking Commission would have quickly shut him down. The key to a successful Ponzi Scheme is to promise lucrative returns but to do so in an unregulated area of the capital markets. Hedge funds are not due to fall under the SEC’s umbrella until February 2006.
No One Would Listen: A True Financial Thriller Page 37
