LAST week's big news was the discovery of the world's largest scam. Bernard Madoff ran a hedge fund which he has admitted was a giant Ponzi scheme. He says it lost $70 billion.
A Ponzi scheme pays out high returns using the investors' own money. The promise of high returns will then lure more investors. Like any pyramid scheme, it is sure to collapse if too many want their money back, since there won't be enough to go around. That happened last week after investors in the Madoff hedge fund tried to withdraw $10 billion.
Hedge funds are like unit trusts, but cater to a small number of select investors. They claim to produce better returns using complex strategies, and have attracted a whopping $2 trillion worldwide.
The Madoff fund said it specialised in a type of trade which is often thought to be a sure thing. It relies on a derivative called stock options.
Like all derivatives - as well as gambling - it is zero-sum, so the best you can do is break even in the long run. Consider trading costs and the returns become negative. It means sure-lose.
The same holds for Madoff's low-risk trading strategy. Professional traders understand that it fails miserably in declining markets, like now.
It defied gravity The Madoff fund, however, showed healthy 10 per cent returns even in down markets. One study showed it had small losses in only seven months out of 15 years. It shouldn't be possible.
A few money managers figured something was fishy and quietly walked away. One - Harry Markopolis - went a step further. He complained to the US Securities and Exchange Commission (SEC) in 1999, saying it was impossible for Madoff to earn its high returns legally.
In 2005, he sent the SEC a report in which he highlighted 29 red flags. He said it was 'highly likely that Madoff Securities is the world's largest Ponzi scheme'. The SEC decided to ignore the report. After all, Bernie Madoff was the highly respected former chairman of the Nasdaq stock exchange.
Harry Markopolis was an unknown. Last week, we found out Harry was right. Bernie was a fraud.
Madoff's 'sure-win' strategy
THE Madoff Hedge Fund said it used a strategy that involves buying shares and selling stock options.
It looks like a sure-thing and works like this: You get a premium of $2 per share for issuing an option that permits a counterparty to buy General Motors shares at $6 per share any time in the next six months.
The counterparty is betting GM shares will rise and you bet they won't. There are four possibilities:
(i) If the GM price remains at $6 or below, you make $2 for selling the option. It's good.
(ii) If the GM price rises to $8 per share, you make $2 for selling the option, but lose $2 ($8-$6) on the option bet. You break even. It's okay.
(iii) If the GM price rises to $15 per share, you lose $7 ($15-$6 and the $2 for selling the option). It's terrible.
There is a way to prevent this disaster. It is to buy GM shares at the time you issue the option.
Then the option's loss is offset by the rise in the value of your shares. You will make $2 no matter how high the stock price rises. It means losses shown above are no longer possible.
(iv) A fourth possibility often goes unmentioned: Once in a while, GM prices are going to fall sharply. Then, you will make $2 for issuing the options but lose much more from the decline in yourGMshares.
These rare but large losses will exactly equal all the small but steady profits, so you will break even in the long-run. With trading costs, you will lose. This is the fatal flaw that kept Bernie Madoff's system from being the sure-thing that he claimed it to be.
This article was first published in The New Paper on December 22, 2008.
