OPERATIONAL ANR INVESTMENT RED FLAGS
AIM 65-5: Describe the operational red flags at BMIS conflicting with the
investmentprofessions standard practices.
Therewereseveral redflags thatshouldhavealertedinvestorsandregulatorsco the prohlemsat BMLS.Operational redflagsincluded thefollowing:
• BMISprovidedvirtuallyallinvestment servicestoitself In mostfunds, diereareseveral serviceproviders, includingabroker toexecutetrades,anadministrator cocalculatethe
netassetvalue(NAV)of thefund,a primerbroker/custodian tocustodythe positions, andan investmentmanager tomanageassets. BMIShandled all ofthesefunctions
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in-house.Itisobviouslyeasier tomanipulateperformancenumbersif thereisno third
partyoversight.Assetsmay bemisappropriatedaswell without properoversightThe firmwasalsoabrokerdealerand market makerinsomestrategies, creating another conflictofinterest.
* Obtcureauditing firm.BMISmanaged$17billion inassets,yetemployedathree-
person auditingfirm operatingina500-square-footoffice. Feederfond*weregenerally
auditedbylarge-namefirmssuch as KPMG.Thislikely gaveinvestors a seuseof security.
However, diese firms hadtorely onthe auditsof odierfirms,namely Friehfingand Horowitz,MadofFsauditingfirm.Why didn'tthesebigfirms verifythelegitimacyof FriehlingandHorowitz?
* Familymembersin key positions.Madoff,hishrother,hissons,hisniece,andhis nephew heldkeypositionsin the firm. Again, like in-houseservicesanda no-nameauditor, it raises the questionof independenceandproperoversight toprotectinvestors. In addition,filingsreportdiatonetofive peoplemanaged theinvestmentadvisory functions,animpossibilitygiven $17 billion ofassetsundermanagement*
* Feestructure.Madoff didnotchargemanagementor performancefees,onlyabrokerage
commission waschargedoneachtrade.As such,feeder firmswereable tochargelarge
managementandperformancefoes.Given thesuccessof diestrategy, itshouldhave raised redflagstoinvestorsanddiefeeder fundsbecauseit doesnotmakesense that BMISwould bewillingtogive upmillionsofdollarsofprofitsinlostfees. Itdid, perhaps, keepfeeder funds satisfied andlookingthe otherway(Le.,ignoringthe red flags).
• NomentionofMadoffallowed andalackof operationaltransparency. Feederfundswere generally prohibitedfrom mentioning eidier Madoffor BMIS in marketingmaterials and privateplacementmemoranda.Madoffdidnot reveal thedollaramountofassets undermanagementeither,whichis rareinanindustrythat likesto bragaboutsuccesses.
Also, investorswere oftennot permittedtovisitBMIS,and MadofF refused toanswer
questions aboutinvestmentstrategies.On-sitedue diligencevisitsweregenerallydenied
orextremelylimited.
* NoSECregistration. BMLSwasnotregistered asaninvestmentadvisoruntil 2E)06.The ruleschangedin2006,closingaloopholethat hadallowed Madoff tocountdiefeeder fundsasclients (in which casehe hadfewer dian 15). The firm stilldidnotregister until Madoffwasforced toadmit he hadmorethan 15clientsinanSECinvestigationof his firm.Probably reassuringinvestorshe didnot, as somefirmsdid, unregisterwhen the LSECreverseddiecountingrule.
* Paper tickets. BMIS used paperticketshymail rather thanallowingclients electronic
accesstodieiraccounts.This practice, combined withno third party investment service
providers/oversight,allowed for end-of-die-day manufacturingof rickets that matched reportedinvestmentresults.
AIM65.6:Describe investment tedflags thatdemonstrated inconsistencies in BMIS’investmentstyle.
Notonlywere there clearoperational red flagsthat shouldhavealertedinvestorshut there wereinvestmentredflagsaswell.Investmentred flagsincluded diefollowing:
• Black-boxstrategy.Asplit-strikestrategycan heprofitablein thelong runhutwill include downmonths,whichwassomethingmissingfromMadoffsperformance.The consistency of theperformanceshould have heen suspicious toinvestors.Investorshave triedto rationalize thetoo-good-to-be-trueperformancebysuggestingexcellent stock
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pickingbyMadoff subsidizingstrategyreturns (to smoodireturns)with market-making profit,or usingleveragetoincrease returns.Somehavesuggested frontrunning,anillegal practicein the UnitedStates.However, nothingexplains the performance besidesablack box.
* Questionable styleexposure.MadofFssplit-strikeconversionstrategy,ashedescribesit, requiresalongput, short call,andlongindexposition.However,style analysisused to
explainMadofPsreturnsfindsthat he hadtobedoingthe opposite of what he claimed.
Quantitativeanalysisof thestrategyshouldhave raisedted flags.
* Illogicalform13Ffilings. BMIS13Ffilingsshowed small investments insmall firms (non-S&P100 companies).Madoffsaidheconvertedtocashatthe endof each quarter
toavoid public analysisof hisstrategy.However,given thehugeamountofassets under
management,enormousamountsofmoneywouldhavetohe moved eachquarter.It simplydoesnotmakesense.
* ImpossiblestrategyusingS&P100options.MadofFsaid thefirm usedS&P100options rathertitanS&P500 options to execute the strategy.This wouldhavebeen prohibitively expensive becausetheyarelesswidelyusedthanS&P500derivatives.Hehad$17 billionof capital undermanagement.Tradeswouldhaveresultedinsharpmovements in the options.Madoflfsaid he usedOTCmarketsbyway ofexplanation.Thisisnot
possihlebecausecounterpartieswouldhave heenlosingyearafteryear,creditexposures for these firmsweretoohigh, andsomecounterparties would havehedged,and thereis
noevidenceof this.Nocounterpartiesliaveheen confirmed,suggestingMadoff wasnot doingwhat hesaid.
Professor'sNote: There were some who did take noteofthe redflags. Aformer
money manager namedHarry Markopolostriedmanytimesover theyears
to alert theSEC. He wasdismissedby regulators. Somebanks also refused
to do business with BMIS beeauseofconcerns. Even basedsolely on public information from the FormADV,a methodology developedbyBrown,
Goetzmann, Liangand Schwarz(2008) would have identifiedBMISasa
problem fund. Butgreed overruled goodsense. In theend, it isapainfullesson
in duediligence. Investorscannot letreturnsblind them toeverythingelse.
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KEY CONCEPTS
AIM65.1
Bernard Madoffraila investmentadvisorybusinessfor more dim 17 years.It all fellapartinDecember2008when Madoff confessed to familymembersthat die business wasagiant Ponzisclieme.
Foundedin i960,Bernard MadoffInvestmentSecurities,LLCwasinitiallya brokerage business.
Madoffwasanearlyadopter of electronic trading and useddieailingCinciimadStock Exchange(CSE) toexploitRule390.The rule allowed for tradingof NYSEstocksaway from dieexchange.He upgradeddiecomputersystems,and theCSE became the first all- electronic trading exchange.
Duetoincreasedcompetitionandfallingmargins in thebrokeragebusiness,Madoff startedan investmentadvisorybusiness that lasted for17years.By2008, the businesswas managing$17billioninassets.
Madoffwasakeyfigureindeveloping theNASDAQ stock market andwasatonepoint chairmanof the NASDAQ board ofdirectors.
AIM65.2
Madoffreferred tohisinvestmentstrategyasasplit-strikeconversionstrategy.The strategy involved thefollowing:
* Takealongpositionin aportfolioof stocks.Theportfoliomusthehighly correlated to theS&P100.
* Writeout-of-die-moneycall optionson theS&P100.The notional principalof the calls
musthe closeinvalueto the equityportfolio.
* Buyout-of-the-moneyputoptionsontheS&P100.The notional principalof theputs
mustapproximatelymirror thevalueof the equityportfolio.
AIM65.3
Feederfundsreported extremelyconsistentpositive returnsrangingbetween 8% and12%, year after year. Negativereturnswere reported ina mere5% of months.Returnswerenot
thatfaroff from theS&P100onaverage, butvolatilitywas markedlylower.
AIM65.4
Asthe market downturn accelerated,investorsstartedwithdrawingfundsatarapidpace. In December 2008,Madoff confessed tofamilymembers diat hisinvestmentadvisorybusiness was'‘agiantPonzischeme.'"Regulators,who had been warnedof prohlemsandredHagsat
BMIS,did notdiscover die scheme.
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AIM65.5
TherewereseveraloperationalredHags thatinvestorsandregulatorsshould havenoticed.
They included:
* BMISprovided virtuallyallinvestment servicestoitself
• Obscureauditingfirm.
• Feestructure.
* Nomentionof MadofFallowedandalackofoperational transparency.
• NoSECregistradon.
AIM65.6
Therewereseveral investmentredflag£that shouldhavebeen noticed.They included:
• Black-boxstrategy.
* Questionable styleexposure.
• Illogical form13Ffilings.
* Impossiblestrategy usingS&P100options.
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CONCEPT CHECKERS
Bernard MadoffInvestmentSecurities,LLC (BMIS) started business in I960:
A. asaninvestmentadvisorybusiness.
B. doingelectronictrading ondieCincinnatiStockExchange,
C. asabrokeragebusiness.
D. asaderivativesclearinghouse.
Whichstatementabout MadofFs split-strikeconversionstrategyis incorrect?
A. Partof thestrategyinvolvessellinganout-of-the-moneycall option.
B. Eventually, gainson dieportfoliowill besupplemented by gainsondielong, out-of-the-moneycall option position.
C. Afloor valueiscreatedby thepurchaseofanout-of-the-money putoption.
D. Alongpositioninaportfolioof stockshighlycorrelated totheS&P100is
required.
Whencomparingthe feeder fundreturnsfor MadofPsstrategywith dieS&P100,
the reportedreturnsoffeeder fundswere:
A. much higherthan theS&P100withhigher volatilitythan theS&P100.
B. much higherthan theS&P100withmuchlowervolatilitythan dieS&P100.
C. muchlower dian theS&P100butwithvolatilitythat approximates diat of 3-month Treasury bills.
D, about thesameastheS&P100butwith much lowervolatilitydian theS&P 100.
1.
2.
3.
4. ThesecuritiesfraudwascaughtatBMIS when:
A. HarryMarkopolossenta17-page letter to theSECdetailingthe red flag?at
BMIS.
B. Madoffssons,finally givingunderdie pressureoflyingfor their father forso many years, called the authorities.
C. theSEC,afteryearsof investigation, compiled enoughevidencetoindict Madoff.
D. MadofFconfessedto hisfamilythat his investmentadvisory businesswasagiant Ponzischeme,
ThefeestructureatBMISwasawarningnoinvestorsbecause Madoff’s firm:
A. cliargedsuchhighperformancefees.
B. only cliargedabrokeragecommission ontrades, C, cliargedsuchhighasset managementfees.
D. did notchargefees ofanysort,relyingonlyon returnsfrom theinvestment strategy’
5.
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CONCEPT CHECKER ANSWERS
1. C BMISbeganasabrokeragebusiness and then movedintoelectronic tradingviathe CincinnatiStockExchange. They ultimatelystartedan investmentadvisorybusinessthat eventuallycaused the firm’s demise.
2. B Thestrategyrequiressellingacallandbuyinga put.Thereisnosupplementtothegainson
dieportfolio,justaceilingand floor createdfrom theoption positions.
3. D Reederhindsreported returnsbetween 8%and12%.ThereturnsarcsimilartotheS&P100 butwith markedlylowervolatility. Fundsshowed positivereturnsin95%of the monthsover
severalyears.Thisconsistencyofpositivereturnsshould have beenared flagforinvestors.
4. D Madnft’didnotgetcaught,butconfessedinthe wakeofarapidly decliningstock market.
InDecember 2003,Madnft’ toldhissons,wife, andbrotherthatthewealthmanagement businesswasagiantPonzi scheme.
5. B Madnft didnotchargeeither managementorperformancefees,onlyabrokeragecommission on trades. Thisissuspiciousin that hisfirmwaswillingtoforgomillionsof dollars of fees.If thestrategywas sogockf,hewould have charged forit
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Thefollowingi*areviewof dieCurrentIssues inFinancial Marketsprinciples designedtoaddressthe AIMstatements setfotlhbvGARP®.Thistopicisalsocovered in: