A recent “tearsheet” for Fairfield Greenwich’s primary Madoff fund reveals how FGG explained some of Madoff’s recent returns to its clients. Such explanations will likely be critical to the question of whether FGG was criminally negligent (or worse) in failing to spot Madoff’s fraud.
The excerpt below describes Fairfield Sentry’s returns for October 2008. As you can see, the fund’s superior performance relative to the S&P 500 is attributed entirely to market timing:
Fairfield Sentry Limited (“Sentry,” or the “Fund”) declined -0.06% net in October 2008 and has
returned +4.50% year-to-date. The S&P 100 Index declined -14.60% during the month and has
declined -30.84% year-to-date.
Sentry’s split-strike conversion (“SSC”) strategy was able to substantially avoid this deep decline
and protect investors’ capital by remaining invested for the entire month in a laddered portfolio of short-dated U.S. Treasury Bills. In fact, the Fund has held a “cash” stance since mid- September once it completed its third implementation cycle of 2008.
Between September 16 and the end of October, the S&P 100 Index declined over 16%; Sentry’s SSC strategy was not exposed to this decline. As we have noted in prior reviews, the Fund seeks to avoid particularly difficult markets by deactivating the SSC strategy and remaining invested in a portfolio of short- dated U.S. Treasury Bills as it awaits the next entry opportunity. The active timing decision to reduce risk during periods of time where it is expected the near-term trading environment is less attractive is an integral part of the SSC strategy. This is a key form of risk management and has been a core technique applied since inception of the Fund.
The modest negative return this month was, however, attributable to the small portion of assets
invested in the Non-SSC program. Overall, the Non-SSC investments have contributed about
0.29% to Sentry’s return since the inception of the program in October 2002. At the end of
October, Non-SSC investments represented approximately 1.10% of Sentry’s portfolio.
In other words, the “split-strike conversion” strategy often had nothing to do with the fund’s returns. In months in which the S&P 500 dropped, the fund’s returns were explained as perfect market timing.
What are the implications of this?
FGG has at least gone to the trouble to explain how its primary Madoff fund generated its returns. This will likely be its main line of defence against the charge that the returns were impossible to achieve using the stated “split-strike conversion” strategy. As FGG explains, the returns were NOT achieved using the vaunted SSC. They were achieved by market timing.
This, however, creates another problem for FGG: Explaining why it believed Madoff possessed such a preternatural ability to time the market.
Academic research has shown that almost no one can time the market consistently, which is why Madoff’s (and FGG’s returns) were so attractive to clients. And yet it is clear that FGG regarded market timing as an “integral part of the SSC strategy” and believed in Madoff’s ability to do it.
Why would FGG believe that Madoff could do something that almost no other manager in the history of the universe has been able to do successfully? Perhaps because they thought he was front-running.
As we’ve discussed, Wall Street was not shocked that Bernie Madoff was busted for cheating (and neither were some of his clients). What Wall Street was shocked by was the method Madoff was using to cheat. The common wisdom was simply that Madoff was using his trading order flow to get an illegal timing edge.
The trouble for FGG, therefore, will come from a need to explain its confidence in Bernie Madoff’s market-timing abilities without attributing them to another illegal scheme. Just attributing Bernie’s success to “proprietary models” won’t cut it–everyone has proprietary models. So FGG will need to produce a more detailed explanation.
If there are internal communications showing that FGG principals suspected that Madoff’s god-like timing abilities were the result of front-running, or if FGG principals explained Madoff’s returns to clients with a wink and nod, the firm is probably legally cooked. A belief that Madoff was front-running would not demonstrate that FGG knew he was running a Ponzi scheme, but it would almost certainly form a sound basis for a fraud or negligence claim.