Madoff lesson: If returns are too good and unnervingly steady, then be sceptical.
Another who guy had remarkably steady returns year after year was none other than Mr. Mad Money, Jim Cramer himself.
Hedge funder and author and Eric Falkenstein recently analysed Cramer’s self-reported returns, as written in his book Confessions of a Street Addict:
He claims to have generated a 12 year track record with 24% annual return after fees. With an average hedge fund taking out 20% of the pnl, and traders taking out 10%, that would be an even higher 34%. Let’s assume he and his traders didn’t take the 10% trader bonus because he was not only the head trader, but the general partner. That implies a 30% average annual return for 12 years.
Now 30% is plausible, but he also states in the book he had only one down quarter. If we assume the probability of a down quarter is p, and he traded for 48 quarters (12×4), that means a maximum likelihood estimate for p of a mere 2.08%. If his 30% returns were normally distributed, one down quarter out of 48 is consistent with an annualized volatility of only 4.25%, for a Sharpe of 7.05 (using a simple Sharpe that ignores the risk free rate).
So how’d he do it? No, he wasn’t a cheat or anything like that, but he did know how to play the system extremely well:
I suspect there were at least three things going on. First, these are unaudited results, and he’s exagerrating somewhat. Secondly, his strategy of paying lots of money to brokers and getting and giving them lots of information, with only $300 million in capital, might generate some abnormal alpha (though Cramer suggests he mainly trades on fundamental analysis, though his trading horizon seems to last weeks, not years). It’s a unique strategy that probably worked well in the 1990’s when broker upgrades and downgrades had more patent insider information–brokers would leak their recommendation changes to accounts generating lots of commissions. Lastly, he admits receiving lots of IPOs, and again, back in the 1990s that was pure arbitrage for anyone smart enough to understand the game. The quid quo pro is commissions to brokers for underpriced IPOs to the trader, all paid for by the issuer (because they only issue new stock once, and are afraid of challenging conventions). Again, with only $300 million in capital, a well executed IPO quid pro quo strategy might have been a viable and highly profitable strategy.
None of this was cheating, nor is it indicative of a genius stock picker.
What Cramer was doing is basically what smart Madoff investors thought he was doing. They thought that he had extra-special insight into market movements courtesy of his market-making business. Cramer, with valuable connections and a relatively tiny assets under management could trade profitably on insight and angles not necessarily related to actual stock analysis. As Falkenstein notes, the ability to gain a lasting and steady edge this way would’ve been impossible with the size of fund Madoff claimed to have.
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