It's being called the biggest investment scam ever. The Economist suggested, partly tongue-in-cheek, that the "Ponzi" scheme be rebranded the "Madoff" scheme due to its size and scope. Newspapers and blogs are humming about the institutions and country club members who fell for Bernie's years of lies. Obviously, especially in retrospect, the flags were crimson. A three-person audit firm was one. The supposedly consistent 10-12% annualized returns was perhaps the biggest; the open interest in the S&P 100 options used to run the split-strike strategy was too low to support $17B of activity.
Even if the volume of options wasn't a deal killer, how would you further critique the steady investment results? This is a problem the investment management business has yet to solve, or at least speak honestly about. What's the most meaningful way to measure investment returns?
Leverage and luck are two culprits. Pile on loads of debt either through margin or options and if things go your way, your returns are juiced. If you're wrong, your bad returns are amplified. Luck can be indistinguishable from skill in the short-term. So track records should count for something.
Naturally, hedge funds and other investment vehicles breed opacity. If they divulged everything than others would simple mimic their strategies and trades and therefore "crowd out" that corner of the investment world and dry up the excess returns. But investors now will demand greater transparency, or at least know that such a way of making money is feasible.
Oddly, most investment managers treat the quality of the return as ancillary--quality in the sense of risk and in probable future results. Since their incentives are to make the coveted 2/20 fees, high risk and high returns go hand in hand. Their traditional tools of return calculation use either beta (the covariance between the asset return and the market return) or the standard deviation of the portfolio, in some relation to returns generated. Again, they're not clear as to how the returns were made, only the final number. They also use a flawed definition of risk, but that's worthy of a separate posting.
Unlevered (equity only), market beating, long-term transparent strategies are the best way to measure investment returns; the final return measured against last year's price movement deviations is not enough. It's fair to ask how a manager justifies his fees and the scorecard that should be used to decide whether he should still have a job. Managers owe their clients restful sleep.
For a group that demands, clarity, loose regulations, detailed financial footnotes, and management candor, the investment management industry needs to come clean on how it measures returns. It would help doctors, teachers, and janitors to know that not everyone that manages money is like Bernie Madoff; some of them actually "add value."
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Disclosure: none
Image: http://www.yu.edu/uploadedImages/Sy_Syms/Dinner_2008/madoff_web.jpg
