Wednesday, January 28, 2009

Madoff's Mistake

One of the inevitable consequences of bear markets seems to be the bust of Ponzi schemes. The explanation seems to be that Ponzi schemes are quite prevalent in our society but can remain undetected during good times. In other words, during good times people seem to have the risk appetite to believe that it is easy to make money consistently without risk of permanent loss. Under this psychological predisposition one presumably can entice his neighbors and friends (all of the caught schemers so far have been men, so women are either better at it or they do not run Ponzi schemes) into believing in unsustainable stories.

The scariest part of the explanation I just used is that, not only applies to "12% return no volatility" (lets call it the "Madoff scheme"), but also to "we only buy growth (i.e. very high p/e) companies" (which we may call the "Internet scheme").

If you think the analogy is preposterous, consider the plight of a tech and/or internet portfolio manager in, say, 1999. His entire portfolio consisted of stocks with high p/e. Sure, many of the companies had been growing at double digit rates, but even a tech manager knows that most companies cannot maintain such growth rates indefinitely. Yet, our manager kept accepting subscriptions, and with the subscriptions bought more of the same expensive stocks, which pushed the price of his portfolio higher making his investors happy. The only difference between this scheme and Madoff's is that it had a chance of succeeding... As much of a chance as Madoff's, that is, who in the absence of a bear market could have kept the system going until his death. Also, since many tech portfolios corrected at least 90%, we can say the result was essentially the same.

In fact, if you think about it, Madoff's scheme had a better chance of outlasting and Internet fund (as it did) because it was not bound by exogenous events like company earnings. His only potential enemy was massive redemptions triggered by a generalized panic which his strategy could have never caused.

As smart as he was, or perhaps because he was never a true manager, Madoff missed one obvious recourse that could have prolonged his tenure: gating.

In case you didn't know, every hedge fund has a clause that allows the managers to reject redemption requests in order to "protect other investors." Of course, the definition of who do you think you protect and against what is in the eye of the beholder. Furthermore, I am sure that many people reading this are cringing at the comparison between a smart-money hedge fund and a run of the mill Ponzi scheme. However, consider the reasoning behind the gate clause: "If I sell to give you your money back I drive the prices down hurting people who do not redeem (including your manager)." If that is the case, then the prices depend on my actions? If they do, what is the exit strategy? Also, what was the effect of my buying on the way up and what performance fees did I pay while I pushed the prices higher?

Of course, if one wanted to speculate (a term seldom used in the Hedge Fund world), one could say that maybe the managers are concerned about losing the 2% fixed fee they continue to charge for managing the assets they cannot sell. Not to mention those managers who have invoked the gating clause because they "...refuse to be the industry's ATM" (true quote from a well know fund manager which implies that they could return your money, they just don't want to).

In summary, I consider a Ponzi scheme any investment were the return depends on successfully attracting new investors. Conversely, if the exit of investors permanently destroys the value of the investment, then it must be some kind of Ponzi scheme as well.

In the end, if Madoff had rejected the redemptions invoking some kind of obscure clause, he would probably still be in business today, even without an auditor.

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