The Frontal Cortex

Hedge Fund Fraud

I find the epic Ponzi scheme of Bernard Madoff morbidly fascinating. He managed to lose 50 billion dollars, which can’t be easy:

A busy stock-trading operation occupied the 19th floor, and the computers and paperwork of Bernard L. Madoff Investment Securities filled the 18th floor.

But the 17th floor was Bernie Madoff’s sanctum, occupied by fewer than two dozen staff members and rarely visited by other employees. It was called the “hedge fund” floor, but federal prosecutors now say the work Mr. Madoff did there was actually a fraud scheme whose losses Mr. Madoff himself estimates at $50 billion.

For years, other investors looked at Madoff’s steady market returns with suspicion – they seemed too good to be true. No matter what happened to the market, Madoff found a way to earn around 10 percent. Of course, we now know how those returns were achieved: with straight up lies.

The larger story, though, is the mistaken belief that allows frauds like Madoff to exist in the first place: our assumption that the market average can be consistently beaten, if only we entrust our money to the right person (or the right algorithm). This is why people rush to invest with the hottest mutual fund managers and are perfectly happy to hand over 20 percent of their profits to a hedge fund. But this belief is false. The market, after all, is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. This inherent randomness was first proposed by the economist Eugene Fama, in the early 1960′s. Fama looked at decades of stock market data in order to prove that no amount of rational analysis or knowledge (unless it was illicit insider information) could help you figure out what would happen next. All of the esoteric tools and elaborate theories used by investors to make sense of the market were pure nonsense. Wall Street was like a slot machine.

I discuss this illusion in my forthcoming book, where I look at silly investor behavior through the prism of our dopamine neurons, which are determined to find rewarding patterns even when no pattern exists:

The lesson here is that it’s silly to try to beat the market with our brain. Dopamine neurons weren’t designed to deal with the unpredictable oscillations of Wall Street. When we spend lots of money on investment management fees, or sink our savings into the latest hot mutual fund, or pursue unrealistic growth goals, we are slavishly following our primitive reward circuits. Unfortunately, the same circuits that are so good at tracking squirts of apple juice will fail completely in these utterly unpredictable situations. “People enjoy investing in the market and gambling in a casino for the same reason that they see Snoopy in the clouds,” says Read Montague. “When the brain is exposed to anything random, like a slot machine or the shape of a cloud, it automatically imposes a pattern onto the noise. But that isn’t Snoopy, and you haven’t found the secret pattern in the stock market.”

That’s why a randomly selected stock portfolio will, over the long run, beat the expensive experts with their fancy computer models. Or why the vast majority of mutual funds in any given year will underperform the S&P 500. Even those funds that do manage to beat the market rarely do so for long. Their models work haphazardly; their success is inconsistent. Since the market is a random walk with an upward slope, the best solution is to pick a low-cost index fund and wait. Patiently. Don’t fixate on what might have been or obsess over someone else’s profits. Investors who do nothing to their stock portfolio – they don’t buy or sell a single stock – outperform the average “active” investor by nearly 10 percent. Wall Street has always searched for the secret algorithm of financial success, but the secret is that there is no secret. The world is more random than we can imagine. That’s what our emotions can’t understand.

Comments

  1. #1 Anibal
    December 15, 2008

    I think those quacks of business that sell wind inject themselves a daily dosis of dopamine in their breakfast before going out.

  2. #2 Mike
    December 15, 2008

    Standard mutual funds, which are just a collection of long positions on equity securities, are going to have their returns dictated much more by luck than by the skill of their managers.

    Hedge funds, however are different. Because their managers are allowed to take hedged positions by buying exotic derivative securities, they should, at least in theory, be able to profit regardless of what happens in the market. Of course, the downside is the risk of catastrophic failure of exactly the kind we’ve seen recently, but that’s why regular investors aren’t allowed to put their money in hedge funds.

    While we’re talking stock markets…

    I can’t remember if I saw this here or at another brain blog. But I saw a really interesting comment that examined the language used in WSJ market recap headlines. It found that, on up days, the market was described in intention-laden terms (“the Dow gained”…”the Dow reached”), while, on down days, the verbs were more inanimate (“the Dow fell”…”the Dow dropped”). The takeaway was that this sort of language influenced people to see the market as intrinsically upwardly-mobile; the market propels itself upwards, and it only loses money because of external causes. Of course, the market does tend to gain in the long run, but this sort of observation has really interesting implications into the psychology that creates bubbles.

  3. #3 JM
    December 15, 2008

    ” Investors who do nothing to their stock portfolio – they don’t buy or sell a single stock – outperform the average “active” investor by nearly 10 percent.”

    Not quite. And herein lies the flaw. Capital allocation plays a role, and also one other thing you forgot.

    If someone had bought the index in 1995 and held it you would be right except you forgot that:-

    * you can’t buy the index. You have to buy the underlying stocks in the appropriate proportion (or pay someone to do it for you). In other words you have to (passively) manage your portfolio

    Once you’ve done that you’re cool, so long as your only objective is to outperform active managers. If on the other hand you want to keep the money you make on the upside, then you need to know when to get out of the market ie. when it starts falling.

    If since you’d had buy and hold the index (with passive changes in the stock mix as the index changed) since 1995 you would have seen 2 booms where you made a lot of money and now 2 crashes where you lost it.

    What you should have done is got out at the top of the two crashes, then you would have kept your money. This is what is meant by active management. Just because very few people are any good at it, doesn’t mean it isn’t possible. Warren Buffet?

    Since you can’t actually get out at the top – because it’s unlikely you’ll recognize it – the best traders “follow the trend”. Going up? They’re long. Going down? They’re short.

    Back test that one. Even with a lag of say 6 months, it works. You don’t need to run very fast, only beat the other runners by putting yourself in the top bracket.

    But I agree, most active managers aren’t good enough to overcome the lead weight of their management fees and transaction costs.

  4. #4 JM
    December 15, 2008

    Sorry I didn’t make my point about not being able to buy the index clearly enough.

    In many comparisons between active management and buy and hold the index, the transaction cost of rebalancing the index is ignored while transaction costs are included in active management. It’s implicitely assumed that transaction costs are zero over the lifetime of the investment – they’re not.

    The second point is that it’s the high management fees that kill the average performance of active management, not the practice itself. Without those fees it is quite possible for an individual manager to outperform the market, just as an elite athlete can outperform me while the entire pool of runners cannot outperform the average of the pool.

  5. #5 TFS
    December 15, 2008

    I do believe you are right about hedge fund managers or any investment advisor earning their keep. However as I am sure you understand that the market is predictable to a certain degree because herd psychology is predictable. Those successful investors either know what to do to move the herd in one direction or the other or what to watch for when others are trying to move the herd. This is why volume is sooo important. Fib numbers can be predictive because people
    watch them and expect things to happen around them.

  6. #6 dzdt
    December 16, 2008

    The history really goes back much farther than the 1960′s. The random walk model for stocks was originally put forward by Bachelier in his 1900 thesis. (See for instance the wikipedia article)

    I’m not familiar with Fama’s work, but don’t think it can possibly show what you claim: “to prove that no amount of rational analysis or knowledge could help you figure out what would happen next.” The best you could hope to achieve analyzing data is to disprove hypotheses that predict a particular sort of relationship between earlier and later data from your data set. There is no way you can draw conclusions about information not in your data set.

    In particular, investors could hope to outperform market averages or chance by bringing outside knowledge to the game. In relationship to particular instances you can certainly find people who do this and profit from it. For the Madoff case, there was an interview with an investment adviser who recommended his clients NOT invest with Madoff. His extra information? He investigated Madoff’s auditor, who seemed wildly understaffed and underexperienced to handle a multi-billion dollar enterprise. For the mortgage-backed-securities meltdown of this year, there are many examples of people who investigated the underlying mortgages and realized there was no way the value of the derivative securities could be justified.

    There really are non-fraudulent hedge funds which make well over 10% returns annually. The key is to take advantage of more information than most of the market is using. This could be computerized trading systems that are 1/2 second faster than everyone else at responding to news, or private research of all sorts into factors affecting the value of stocks or other securities, or fancy theoretical models relating the value of one thing to the value of another.

  7. #7 milt tomkins
    December 16, 2008

    This is a great blog!!! glad I found it..….very educational…thank you…I will put it on my favorites list.. I also learned a lot about trading strategies and scams from 3 other great books. Hedge Fund Trading Secrets Revealed..by Robert Dorfman..and Confessions of a Street Addict of course by Jim Cramer..written before he got really famous.and Richard ARMS..STOP AND MAKE MONEY….all 3 are riveting and very informative. You should check them out if you like reading behind the scenes stuff about hedge fund and what methods they use to make money.

  8. #8 Donna B.
    December 16, 2008

    dzdt — “There is no way you can draw conclusions about information not in your data set.”

    Correct me if I’m wrong, but isn’t that the point Fama makes?

  9. #9 bwv
    December 16, 2008

    Fama demonstrated that past prices contain no information that can be used to beat the market,not that “no amount of rational analysis or knowledge” can result in excess profits. Most investment managers look to some combination of current valuation and potential future growth in their investment decisions. Fama went on to demonstrate that small cap and value (stocks with lower than average Price to Book ratios) actually have outperformed the market after adjusting for statistical measures of risk. Fama argues that this is because of unseen risk factors while others argue it is an anomoly.

    The stock market is like any other kind of market where buyers and sellers transact at agreed upon prices. The price of a stock is an estimate of the value of the future cash flows of the company. The only mechanism for pricing stocks is investors who are not passive index investors and who do attempt to buy or sell according to an estimate of the fair value. This would say that the odds of beating the market should be comparable to succeeding in any other highly competitive business enterprise, small but doable for those who devote time and resources to the problem. The complication is that differentiating skill from luck is a very difficult endeavor, even over long time periods.

  10. #10 Elizabeth
    December 17, 2008

    I do not know if it correct to say MADOFF lost $50B. The $50B actually never existed.

    For example, let’s say I gave Madoff $1M to invest. Claiming a 10% return, he could easily give me $100,000 back… and still have $900,000 of my money. But let’s say he has a 20% return, … now even after giving me $200,000, he still has $800,000 of my money even if he never generated any proceeds with my money. Now let’s say that when I give him my $1M, I just want to see it grow… he merely tells me it is now $1.2M when, in fact, it is still just the $1M I gave him. But now, I have a friend who wants in on the action. Now, Madoff has $2M to play with… and with such returns, who is going to take their money out of the game? Ponzi schemes work when more money is coming in than going out… as soon as more people want their money (as in difficult financial times), the scheme collapses.

    Of course, over time, on PAPER, I might have doubled my $1M in a few years given 20% returns. Again, who takes the money off the table with such great returns… apparently no one, until the financial crisis of the past few months.

    It is possible, that I, by withdrawing my 10-20% annual returns, even partially, might have gotten more than the original $1M out of the investment. Of course, I was being lead to believe that I had an account that was growing every year, even if I took some money out.

    But the point is, it was all just written records… it is possible that the total amount of money was probably never more than what Madoff collected from people on their original investments.

    It would be very curious to know what people invested, and what their capital gains, dividends, and plain old distributions / withdrawals actually add up to. Over time, some people may have received more than what they put in.

    The people who never took anything out are the ones who were hurt the most as they never saw any of their money again, and probably never will, but it is doubtful that it ever accumulated to what the ‘pretended” 10-20% gains claimed.

  11. #11 Elizabeth
    December 17, 2008

    I do not know if it is correct to say MADOFF lost $50B. The $50B actually never existed.

    For example, let’s say I gave Madoff $1M to invest. Claiming a 10% return, he could easily give me $100,000 back… and still have $900,000 of my money. Now, let’s say he has a 20% return, … now even after giving me $200,000, he still has $800,000 of my money even if he never generated any proceeds with my money. Now let’s say that when I give him my $1M, I just want to see it grow… he merely tells me it is now $1.2M when, in fact, it is still just the $1M I gave him. But now, I have a friend who wants in on the action. Now, Madoff has $2M to play with… and with such returns, who is going to take their money out of the game? Ponzi schemes work when more money is coming in than going out… as soon as more people want their money (as in difficult financial times), the scheme collapses.

    Of course, over time, on PAPER, I might have doubled my $1M in a few years given 20% returns. Again, who takes the money off the table with such great returns… apparently no one, until the financial crisis of the past few months.

    It is possible, that I, by withdrawing my 10-20% annual returns, even partially, might have gotten more than the original $1M out of the investment. Of course, I was being lead to believe that I had an account that was growing every year, even if I took some money out.

    But the point is, it was all just written records… it is possible that the total amount of money was probably never more than what Madoff collected from people on their original investments.

    It would be very curious to know what people invested, and what their capital gains, dividends, and plain old distributions / withdrawals actually add up to. Over time, some people may have received more than what they put in.

    The people who never took anything out are the ones who were hurt the most as they never saw any of their money again, and probably never will, but it is doubtful that it ever accumulated to what the ‘pretended” 10-20% gains claimed… it was all a paper fiction.

  12. #12 Bart Mallon
    January 3, 2009

    Unfortunately the Madoff scandal has raised the likelihood that regulators will require hedge fund managers to register in some capacity which will have a chilling effect on those managers who are starting a hedge fund in the new year.

  13. #13 mirc
    May 17, 2009

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  14. #14 Margaret
    August 24, 2009

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