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Opinion: Hard to spot Bernie Madoff’s hoax but this red flag – and still remains – a clue


Many people are taking the wrong investment lessons from Bernie Madoff’s infamous career.

Madoff, who died earlier this month, is a hedge fund manager, the mastermind of the biggest Ponzi scheme in history. Many commentators are using his death to participate in what sums up with Monday morning’s news quarter, smugly asserting that – if they were given the chance to invest in his hedge fund for the day. – they will know better. They said his profits were too good to be true.

The reason this is the wrong lesson to take is that it has gone too far. Sometimes, an investment manager making a return seems too good to be true – but nevertheless, the return is real.

Perhaps the most famous example is the hedge fund of Renaissance Technologies, the Medal Fund. The Wall Street Journal reports that the fund generated an annual net return of 39% from fees for 31 years through 2018. The fund is also very consistent: On a pre-fee basis, it never had a loss year and on a after-fee basis it was haven’t had one since 1989, when it lost 3.2%.

To put that in context, Warren Buffett, CEO of Berkshire Hathaway
BRK.A,
+ 0.72%
,

BRK.B,
+ 0.92%

generating a “only” 15.5% annual return in the same 31-year period. S&P 500’s
SPX,
+ 1.09%

profit including dividend while it is 10.2%.

On the face of it, the Medal Fund’s returns seem too good to be true. But some of the statisticians I contacted told me that they very much seemed real. One is Brad Cornell, professor emeritus of finance at UCLA. After analyzing Medallion’s profileHe told me in an email: “The only conclusion I can reach is that there are cases where things seem too good to be true, but then reality comes true.”

So, what is the appropriate lesson to take from Madoff’s “too good to be true” performance? For the answer, I turned to Campbell Harvey, a professor of finance at Duke University. He has the special point of being able to say “I told you that” about Madoff’s profile, as he had previously warned others that there was something puzzling about it.

In an interview, Harvey said that many years ago, he was hired as a consultant by a wealthy investor who was considering investing with Madoff. “It only took me 5 or 10 minutes to review Madoff’s performance claims, based on the strategy he says he’s following, to know that his profile is unreliable.”

The sign of the story, explains Harvey, is the contradiction between the inherent risk of the option strategy Madoff says he is following and the unusual consistency of the returns he has reported. According to Harvey, “the reported volatility was too low to be believed”.

Lesson Harvey learned: To judge whether a manager’s performance is credible or not, you have to go beyond the numbers. The appraisal process you should do involves analyzing the manager’s strategy based on those numbers. It would be a red flag if you spot any inconsistencies between his reported returns and what you calculated his strategy should have produced, both in terms of gross margins and fluctuations.

To be sure, you may not feel eligible for this assessment. If so, then find someone. What you pay them now can save you much later.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected]

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