Wall Street know Bernie Madoff well. His brokerage firm, Madoff
Securities, helped kick-start the Nasdaq Stock Market in the early
1970s and is now one of the top three market makers in Nasdaq
stocks. Madoff Securities is also the third-largest firm matching
buyers and sellers of New York Stock Exchange-listed securities.
Charles Schwab, Fidelity Investments and a slew of discount
brokerages all send trades through Madoff.
Some folks on Wall Street think there's more to how Madoff
(above) generates his enviable stream of investment returns than
meets the eye. Madoff calls these claims "ridiculous."
But what few on the Street know is that Bernie Madoff also
manages $6 billion-to-$7 billion for wealthy individuals. That's
enough to rank Madoff's operation among the world's three largest
hedge funds, according to a May 2001 report in MAR Hedge, a trade
more, these private accounts, have produced compound average annual
returns of 15% for more than a decade. Remarkably, some of the
larger, billion-dollar Madoff-run funds have never had a down year.
Barron's asked Madoff Friday how he accomplishes this, he said,
"It's a proprietary strategy. I can't go into it in great
the firms that market Madoff's funds forthcoming when contacted
earlier. "It's a private fund. And so our inclination has been
not to discuss its returns," says Jeffrey Tucker, partner and
co-founder of Fairfield Greenwich, a New York City-based hedge-fund
marketer. "Why Barron's would have any interest in this fund I
don't know." One of Fairfield Greenwich's most sought-after
funds is Fairfield Sentry Limited. Managed by Bernie Madoff,
Fairfield Sentry has assets of $3.3 billion.
hedge-fund offering memorandums describes his strategy this way:
"Typically, a position will consist of the ownership of 30-35
S&P 100 stocks, most correlated to that index, the sale of
out-of-the-money calls on the index and the purchase of
out-of-the-money puts on the index. The sale of the calls is
designed to increase the rate of return, while allowing upward
movement of the stock portfolio to the strike price of the calls.
The puts, funded in large part by the sale of the calls, limit the
Among options traders, that's known as the "split-strike
conversion" strategy. In layman's terms, it means Madoff
invests primarily in the largest stocks in the S&P 100 index --
names like General
Electric , Intel
. At the same time, he buys and sells options against those stocks.
For example, Madoff might purchase shares of GE and sell a call
option on a comparable number of shares -- that is, an option to buy
the shares at a fixed price at a future date. At the same time, he
would buy a put option on the stock, which gives him the right to
sell shares at a fixed price at a future date.
strategy, in effect, creates a boundary on a stock, limiting its
upside while at the same time protecting against a sharp decline in
the share price. When done correctly, this so-called market-neutral
strategy produces positive returns no matter which way the market
split-strike conversion strategy, Fairfield Sentry Limited has had
only four down months since inception in 1989. In 1990, Fairfield
Sentry was up 27%. In the ensuing decade, it returned no less than
11% in any year, and sometimes as high as 18%. Last year, Fairfield
Sentry returned 11.55% and so far in 2001, the fund is up 3.52%.
returns have been so consistent that some on the Street have begun
speculating that Madoff's market-making operation subsidizes and
smooths his hedge-fund returns.
Madoff Securities do this? Access to such a huge capital base could
allow Madoff to make much larger bets -- with very little risk --
than it could otherwise. It would work like this: Madoff Securities
stands in the middle of a tremendous river of orders, which means
that its traders have advance knowledge, if only by a few seconds,
of what big customers are buying and selling. By hopping on the
bandwagon, the market maker could effectively lock in profits. In
such a case, throwing a little cash back to the hedge funds would be
no big deal.
Barron's ran that scenario by Madoff, he dismissed it as
some on Wall Street remain skeptical about how Madoff achieves such
stunning double-digit returns using options alone. The recent MAR
Hedge report, for example, cited more than a dozen hedge fund
professionals, including current and former Madoff traders, who
questioned why no one had been able to duplicate Madoff's returns
using this strategy. Likewise, three option strategists at major
investment banks told Barron's they couldn't understand how Madoff
churns out such numbers. Adds a former Madoff investor: "Anybody
who's a seasoned hedge- fund investor knows the split-strike
conversion is not the whole story. To take it at face value is a bit
dismisses such skepticism. "Whoever tried to reverse-engineer
\, he didn't do a good job. If he did, these numbers would not be
unusual." Curiously, he charges no fees for his
money-management services. Nor does he take a cut of the 1.5% fees
marketers like Fairfield Greenwich charge investors each year. Why
not? "We're perfectly happy to just earn commissions on the
trades," he says.
so. But consider the sheer scope of the money Madoff would appear to
be leaving on the table. A typical hedge fund charges 1% of assets
annually, plus 20% of profits. On a $6 billion fund generating 15%
annual returns, that adds up to $240 million a year.
lessons of Long-Term Capital Management's collapse are that
investors need, or should want, transparency in their money
manager's investment strategy. But Madoff's investors rave about his
performance -- even though they don't understand how he does it.
"Even knowledgeable people can't really tell you what he's
doing," one very satisfied investor told Barron's. "People
who have all the trade confirmations and statements still can't
define it very well. The only thing I know is that he's often in
cash" when volatility levels get extreme. This investor
declined to be quoted by name. Why? Because Madoff politely requests
that his investors not reveal that he runs their money.
Madoff told us was, 'If you invest with me, you must never tell
anyone that you're invested with me. It's no one's business what
goes on here,'" says an investment manager who took over a pool
of assets that included an investment in a Madoff fund. "When
he couldn't explain \ how they were up or down in a particular
month," he added, "I pulled the money out."
For investors who aren't put off by such secrecy, it should be noted
that Fairfield and Kingate Management both market funds managed by
Madoff, as does Tremont
Advisers , a publicly traded hedge-fund advisory firm.