Stock

FA Heart: Bernie Madoff's fraud was arduous to identify, however that crimson flag was and is a clue

Many draw the wrong lessons from Bernie Madoff's infamous career.

Madoff, who passed away earlier this month, was the hedge fund manager who started the largest Ponzi program in history. Taking the opportunity of his death to focus on what boils down to Monday morning quarterbacking, many commentators smugly insist that they would have known better if they had had the opportunity to invest in his hedge fund sooner. Its returns were too good to be true, it is now said.

The reason this is the wrong lesson is because it is going too far. Sometimes an investment manager makes returns that seem too good to be true – but are real nonetheless.

Perhaps the best-known example is Renaissance Technologies' flagship hedge fund, the Medallion Fund. The Wall Street Journal reports that the fund generated an annualized net fee return of 39% for the 31 years through 2018. The fund was also remarkably consistent: on a pre-fee basis, it never had a year of loss, and so on, an after-fee basis that hasn't been there since 1989 when it lost 3.2%.

Warren Buffett, the CEO of Berkshire Hathaway
BRK.A,
+ 0.72%,

BRK.B,
+ 0.92%
achieved an annual return of “only” 15.5% over the same period of 31 years. The S&P 500
SPX,
+ 1.09%
The return, including dividends, was now 10.2%.

At first glance, the Medallion Fund's returns seem too good to be true. But several statisticians I have contacted have told me that they seem very real. One is Brad Cornell, Professor Emeritus of Finance at UCLA. After analyzing Medallion's record, he told me in an email, "The only conclusion I could come to is that there are times when things seem too good to be true and then actually turn out to be turn out to be true. "

Then what is the correct lesson to learn from Madoff's "too good to be true" performance? For answers, I turned to Campbell Harvey, a finance professor at Duke University. He has the distinction of being able to say "I told you" about Madoff's file, having warned others in advance that something was wrong with it.

In an interview, Harvey said he was hired as a consultant many years ago by a wealthy investor who was considering investing in Madoff. "It only took me five or ten minutes to examine Madoff's performance claims in the light of the strategy he was pursuing to know that his record wasn't credible."

The tell-tale sign, Harvey explained, was the inconsistency between the inherent risk of the options strategy Madoff pursued and the extraordinary consistency of the returns he reported. His reported "volatility was far too low to be believable," said Harvey.

The Lesson Harvey Draws: In order to gauge whether a manager's track record is credible, you need to go beyond the numbers themselves. The due diligence that you should go through includes analyzing the manager's strategy in light of these numbers. It would be a red flag if you found inconsistencies between his reported returns and what you calculated for his strategy, both in terms of gross earnings and volatility.

Of course, you may not feel qualified to do this due diligence. If so then find someone who is. What you pay now can keep you from paying dearly later.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings track investment newsletters that pay a flat fee for testing. He can be reached at mark@hulbertratings.com

More: Get ready to sell $ 178 billion before capital gains tax hike. These are the stocks most at risk.

Also read: The psychology of a stock market bubble

Related Articles