Given its prominence, size, and remarkable returns, which were hard to fathom given the difficulty of consistently beating the market averages, RenTec had naturally attracted the interest of the SEC. Hedge funds themselves weren’t directly regulated by the SEC or anybody else, but they had to abide by securities laws. The SEC had asked RenTec for numerous documents and records, including internal e-mails. So far Thanasules hadn’t found anything suspicious, but as he sifted through Meritage’s assets, he discovered that Meritage didn’t simply invest directly in other hedge funds, like most funds-of-funds. It had entered into a so-called total return swap with another fund-of-funds, HCH Capital, effectively paying HCH for the returns and risk associated with one of its investments. So far it looked like it had been a very profitable investment for Meritage, since the fund it had swapped into had delivered extraordinarily consistent and quite high returns. It looked like it had never had a down quarter, even after the technology bubble, and only a handful of down months. Meritage had to gain access to the fund using a swap, because the fund was so successful and sought-after that only the chosen few were allowed to invest, handpicked by the fund’s manager. Given Simons’s reputation and track record, most funds would have been thrilled to have Meritage among its investors. But when Meritage tried to invest, Bernard L. Madoff had turned Simons down.
The name Madoff meant nothing to Thanasules. But from the RenTec e-mails, he could tell that Madoff was a subject of concern to the people there, who were, after all, some of the most sophisticated people in the hedge fund world. Since they were only indirect investors in the Madoff fund, they didn’t get account statements or have direct contact with Madoff, relying instead on what they could learn from HCH and other sources. They didn’t really know what strategies Madoff used, or how he earned such consistent returns–more consistent than even their flagship Medallion fund. On November 13, 2003, Nat Simons wrote an e-mail to his father and other investment committee members:
We at Meritage are concerned about our HCH investment. First of all, we spoke to an ex-Madoff trader (who was applying for a position at Meritage) and he said that Madoff cherry-picks trades and “takes them for the hedge fund.”
This alone was a red flag, since cherry-picking is illegal unless the practice is fully disclosed to investors. Cherry-picking consists of executing many trades, and then allocating the most profitable ones to favored investors, inflating the returns at the expense of others.
The e-mail continued:
He said that Madoff is pretty tight-lipped and therefore he didn’t know much about it, but he really didn’t know how they made money. Another person heard a similar story from a large hedge fund consultant who also interviewed an ex-trader. The head of this group told us in confidence that he believes Madoff will have a serious problem within a year. . . .
Another point to make here is that not only are we unsure as to how HCH makes money for us, we are even more unsure how HCH makes money from us; i.e., why does [Madoff] let us make so much money?
Here Simons was evidently referring to the fact that Meritage charged investors a percentage management fee plus a percentage of the gain, but Madoff charged zero percent, and only a modest four-cents-per-share trading commission.
Why doesn’t he capture that himself? There could well be a legitimate reason, but I haven’t heard any explanation we can be sure of. Additionally, there is a $4 billion Madoff pass-through fund (Fairfield Sentry) that charges 0 and 20% and it’s not clear why Madoff allows an outside group to make $100 million per year in fees for doing absolutely nothing (unless he gets a piece of that). [A pass-through, or “feeder,” fund raises money from investors and then simply invests it in another fund, in this case Madoff, making no investment decisions of its own.] The point is that as we don’t know why he does what he does, we have no idea if there are conflicts in his business that could come to some regulator’s attention. Throw in that his brother-in-law is his auditor and his son is also high up in the organization and you have the risk of some nasty allegations, the freezing of accounts, etc. To put things in perspective, if HCH went to zero it would take out 80% of this year’s profits.
More red flags, especially if Madoff’s auditor wasn’t really independent. (Simons was wrong about Madoff’s auditor, but his point was well taken. The auditor, David Friehling, wasn’t Madoff’s brother-in-law, but he was a close Madoff family friend, a one-man operation in suburban New Jersey, and an investor in Madoff’s fund–a blatant conflict of interest.) Moreover HCH–Madoff–accounted for an astoundingly high percentage of Meritage’s profits, especially for an operation that was supposed to be diversified. Simons suggested pulling out of the HCH position entirely:
Perhaps the best reason to get out is that we don’t really expect to make an outsized return on this investment. Sure it’s the best risk-adjusted fund in the portfolio, but on an absolute return basis it’s not that compelling (12.6% average return over the last three years). If one assumes that there’s more risk than the standard deviation would indicate, the investment loses its luster in a hurry.
It’s high season on money managers, and Madoff’s head would look pretty good above Eliot Spitzer’s mantel. [Spitzer was then New York’s aggressive attorney general.] I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk reward on this bet is not in our favor.
Please keep this confidential.
Troubled by the suggestions in Simons’s e-mail, Thanasules looked for a reply, and found one written the next day by Henry Laufer, a former math colleague of James Simons at SUNY Stony Brook who now held the title of “chief scientist” at Renaissance. “I share the concern at Meritage about the HCH investment,” Laufer began.
In Nat’s note, I am most worried about the new information in the statement that “Madoff cherry-picks trades and takes them for the hedge fund.” We at Renaissance have totally independent evidence that Madoff’s executions are highly unusual. . . . In all, I very much agree with the sentiment “It’s high season on money managers, and Madoff’s head would look pretty good above Eliot Spitzer’s mantel.”
A week later, Paul Broder, RenTec’s risk manager, reported the results of some further work he’d done on the Madoff exposure. He’d examined the account statements from investors in Madoff’s funds, and compared them to the strategy Madoff said he used: a “split-strike forward conversion” strategy, as Madoff had told both clients and Michael Ocrant, a reporter for
MAR/Hedge
, a hedge fund industry newsletter, who’d raised questions about Madoff in a 2001 article “Madoff Tops Charts; Skeptics Ask How”:
Skeptics who express a mixture of amazement, fascination, and curiosity about the program wonder, first, about the relative complete lack of volatility in the reported monthly returns.
But among other things, they also marvel at the seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative; and the related ability to buy and sell the underlying stocks without noticeably affecting the market.
Another article in
Barron’s
, “Don’t Ask, Don’t Tell,” by Erin Arvedlund, raised similar questions. “Even adoring investors can’t explain his steady gains,” she reported.
Although it sounds sophisticated, the split-strike strategy is a relatively simple options strategy used by many traders and fund managers to reduce risk. Madoff bought stocks–he described them as a “basket” of stocks mirroring the S&P 100, which are the most liquid, large-capitalization stocks. Then he protected the portfolio from falling prices by buying a put on the S&P 100 index (known by its trading symbol, the OEX). A put is like insurance, since it gives the buyer the right to sell an index representing the underlying stocks at the designated strike price. To pay for the puts, Madoff sold calls on the basket of stocks. Calls give the buyer the right to buy the underlying stocks at the strike price. By selling calls on his stocks, Madoff sacrificed any further gains if the stock prices went above the strike prices.
Buying puts to reduce or prevent loss while selling calls that limit gains is called a “collar,” one of the most common options strategies. But by reducing risk and incurring additional transaction costs, the strategy usually produces lower long-term returns than an unhedged strategy. Although it may smooth out returns, it will sharply underperform market averages in a strong bull market. In a bear market, it may outperform, but will still have trouble showing gains, since the strategy is a hedge, not a bet on declining prices. So many investors were using the strategy that, by 2004, returns had shrunk. So the fact that Madoff used the split-strike strategy didn’t impress Broder. On the contrary, it made Madoff’s high returns even more mysterious.
Broder had compared Madoff’s account statements to volume and pricing data on the OEX options that figured so heavily in Madoff’s strategy. He summarized his findings in an e-mail:
I have kept this note to a restricted circulation. I had some further conversations . . . on the Madoff data. I also looked at some daily volume data on and around the OEX option transaction dates as indicated by Madoff’s statements. I was specifically trying to address the question of how big a fund base can Madoff trade with this strategy by focusing on the option volume numbers.
1. Recall that Madoff’s strategy involves a collar, that is a put and a call. The volume numbers provide total calls executed on the OEX and total puts. In the two independent sets of statements . . . the strikes were always the same for both accounts. Make the generous assumption that 50% of the volume was in the most liquid strike . . . By this measure Madoff could only do $750m[illion]. That is with him doing 100% of the option volume in his chosen strike (with the generous 50% assumption). Let’s assume that he spreads it over 3 days–so we get to 2.1bln–still far short of the target numbers.
In others words, assuming Madoff accounted for
all
of the trading volume in the most liquid strike price, and allocating 50 percent of his contracts to that strike price, he could only account for $750 million in assets, when Madoff was believed to be managing $15 billion.
2. Another important point: In every case . . . the options strike (call) is the one closest to the close in the underlying market. Of course the market is not known until the close!! Does this mean that all the options are done almost at the close?
3. The volume does seem to spike on the days when Madoff is executing by a factor of 3-4. This must produce deterioration in execution prices–and for 15bln!
4. When we examined the issue before, we concluded that maybe he does the options in the OTC market. [The OTC, or over-the-counter market, consists of direct trades between two parties. Since it’s a private transaction, the trades aren’t reported on any exchange.] We have spoken to several market makers in OTC equity options. [A market maker maintains buy and sell prices for securities and other assets at which it will enter into a transaction, thereby providing liquidity and “making a market” for buyers and sellers.] Recall . . . that Madoff had said it was necessary to spread trades over several days–why if you are doing OTC? [Large orders typically move price, which is why they would be spread over several days on an exchange. But two private parties could do a trade of any magnitude at an agreed price.]
5. Recall point 2. This would indicate that the OTC options would also have to be done at the end of the day (to get a strike near the close). Are we to believe that the market makers would take on $15bln of market risk at the close? Of course they might (might!!!) be willing to take the options risk if Madoff provided the market hedge in the underlying (i.e., they did the whole package with Madoff) but we already know that the trades in the underlying, compared with the closing prices, would leave the OTC counterparty showing losses (as our account always shows gains).
6. Of course ALL of our trades are with Madoff as the principal–so our option positions are OTC with Madoff so he can choose to use any strike, and any total volume he chooses, but the risk must be covered somewhere if he is doing the trades at all?
So we need an OTC counterparty (not necessarily a bank) who is willing to do the basket of the options plus the underlying with Madoff at prices unfavorable for the OTC counterparty–in 10-15bln!!!
Any suggestions who that might be?
None of it seems to add up.
And it wasn’t just the massive but strangely undetectable volume of Madoff’s trading that made Broder suspicious. The prices at which he bought, sold, and executed options were amazingly profitable. Madoff’s ability to predict when to buy and sell stocks was better than anyone Broder had ever encountered. As he later put it, “I knew it wasn’t possible because of what we do.” The Renaissance officials also noticed that Madoff didn’t consistently follow a split-strike conversion strategy. Sometimes he withdrew from the market entirely, moving his accounts to all cash. Essentially he was market timing–a notoriously difficult quest–and he was doing this, too, with extraordinary success, managing to get out of the market in exactly those months when the split-strike strategy would have generated losses. “We had no idea . . . how he managed to do that,” RenTec’s Laufer later said. “We didn’t understand what he was doing. We didn’t understand how he was doing what he was doing.”