One of the more mystifying elements (among many) regading l’affaire Madoff is the number of professionals such as fund screeners such as “funds of funds” to identify the returns reported by Madoff as impossible with his strategy. A basic knowledge of options would lead one to the conclusion that his relatively basic strategy would produce lower returns and less volatility than the market, but would not produce years without a single annual loss. It shouldn’t have taken a major research project such as the one described in this wsj article to make that discovery:
Madoff Strategy Put to Test
Credit Suisse Sees Gains of 8.6%; Factoring In a Collar
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By TENNILLE TRACY
If Bernard Madoff had employed the investment strategy that he allegedly told investors he was using, then what would his returns have actually looked like?
According to a study by Credit Suisse, the tactics that Mr. Madoff purported to use -- incorporating trades in both stocks and options -- would have generated an annual average return of 8.6%, beating the Standard & Poor's 500-stock index.
Several of Mr. Madoff's investors have said they were told they had gains of about 10% for many years.
In determining the estimated returns, Credit Suisse developed a simulation of Mr. Madoff's investment strategy going back to 1995, incorporating the use of the "split-strike conversion" that Mr. Madoff allegedly said he was using.
Commonly known as a collar, the strategy involves the purchase of stock, the sale of call options and the purchase of put options. Calls convey the right to buy a company's stock at fixed prices, while puts convey the right to sell it.
Although viewed with some suspicion since Mr. Madoff's arrest in December, the collar strategy is routinely employed by professional investors who want to protect their stock holdings against declines…..
After conducting the study, Ed Tom, Credit Suisse's head of equity derivatives strategy, said the level of returns that Mr. Madoff said he produced is far less startling than the risk-return ratio, or the consistency by which he produced them. Even if Mr. Madoff pursued collar strategies, Mr. Tom said, it would be nearly impossible to protect a stock portfolio against the normal fits and starts of the market.
"I think it's important going forward that people know what the return characteristics look like," Mr. Tom said.
In fact there is an existing public mutual funds which makes public its strategy and holdings and is available to every investor at non exorbitant fees. The fund, the Gateway Fund (GATEX) which I make use of in my client portfolios is a true “hedged fund” that reduces volatility but potentially sacrifices big returns.
The fund strategy is described as follows by the manager:
• A hedged equity portfolio that seeks to generate better risk-adjusted returns than "long-only" equities or core fixed-income funds.
• The fund seeks to generate cash flow by selling index calls against a diversified equity portfolio while purchasing protective index puts to help reduce downside exposure.
• Historically has outpaced inflation and the bond market while seeking to generate equity-like returns with bond-like volatility.1
• Potential diversifier for almost any portfolio due to its historically attractive risk/return profile, low beta relative to the S&P 500, and low correlation relative to the Lehman Aggregate Bond Index.
(sound familiar ? look again at the description of Madoff’s (supposed) strategy above.
The result of the strategy:
Lower volatility than a long only positions
Better returns than the market during down years for the mkt or during very stable markets.
Lower returns than the market when the market performs very strongly.
And
Cannot guarantee that there will be no negative years for the fund.
Average annual returns – Class A shares2 as of 12/31/08
1 yr 5 yrs. 10 yrs. Since 1/1/88*
Total return at NAV1 -13.92% 2.75% 3.52% 7.80%
Total return with MSC2 -18.88 1.55 2.91 7.50
S&P 500 Index3 -37.00 -2.19 -1.38 8.80
Barclays Agg Bond Index 5.24 4.65 5.63 7.45
In sum, the purported Madoff strategy can make sense for part of a portfolio and is readily available in a public mutual fund. The returns Madoff reported for this strategy were impossible to achieve. And any responsible advisor with a basic knowledge of options should have known that.
(The above is not a recommendation to purchase any security or fund.)
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