As we review more documents from Fairfield Greenwich Group, we are developing a better understanding of how the firm explained Madoff’s returns to itself and its clients. We still have yet to see evidence that FGG knew Madoff was running a Ponzi scheme. The documents do suggest, however, that FGG:
- Closed its eyes, shoved its fingers in its ears, and hummed as Madoff made the firm $500 million of fees in the past five years (and more before that).
- Took all the credit for the trading strategy and based its fees on the premise that FGG, not Madoff, was the brains behind the operation. The firm almost always spoke as though it managed its primary Madoff fund, Fairfield Sentry, itself. If Madoff ever came up in FGG’s marketing materials, he was described as a “broker.”
- Knew that the key driver of the fund’s stated returns was NOT the “split-strike conversion strategy” but market timing. The firm never explained, however, how this superb market timing was supposedly executed.
As investigators dig through the FGG wreckage, therefore, one of the key questions will be how partners like Walter Noel, Jeff Tucker, and Andres Piedrahita explained Sentry’s astonishing market-timing ability to themselves and their clients.
If the best answer is “proprietary models,” FGG may well be found to have been negligent in its failure to conduct adequate due diligence. Consistent market timing is extraordinarily difficult, and Madoff’s claim that he could do it when others couldn’t should have set the same alarm-bells clanging at FGG as it did elsewhere.
We suspect that the more likely answer is “We thought he was front-running.” Lots of other folks on Wall Street thought Madoff was front-running, including some major Madoff investors, and, for most folks, this seemed to explain his preternatural timing ability. The trouble for FGG with this explanation is twofold: First, front-running is illegal. Second, the firm doesn’t mention front-running it its fund documents. If FGG did rationalize Madoff’s performance on the suspicion that he was front-running, the firm will likely be exposed to charges of fraud.
FGG itself is almost certainly toast regardless of what investigators find. The legal distinctions will come into play with respect to victims’ ability to go after the personal assets of Noel, Tucker, Piedrahita, et al.
Fairfield Sentry Semi-Annual Review
As you can see from this excerpt of a February 2008 semi-annual review of the Fairfield Sentry fund below (full document embedded beneath), FGG clearly acknowledges the importance of market timing to the fund’s success. It does not, however, offer any insight into how this timing is achieved.
To put this in the terms of another competitive endeavour: This is akin to a football coach explaining his team’s success by saying that the strategy is to run for short gains up the middle…and then casually mentioning that that half the time it just throws (and completes) 100-yard bombs.
The other obvious absurdity here is the idea that you would ever need to run a “split-strike strategy” if your timing was this good. The split-strike strategy limited gains in bull markets, so if you could always see these bull markets coming, why would you ever implement it? Why wouldn’t you just switch between an S&P 500 index fund and Treasuries? To again put this in football terms, why would a coach ever run for short gains up the middle when he knew that, at will, he could just complete 100-yard bombs?
As many of our investors know, Sentry applies a synthetic index replicator and options trading strategy known as the split strike conversion (“SSC”) and alternates between periods of time invested in this combined stock/options position and time invested in a cash stance consisting of short-dated U.S. Treasury Bills. As such, the Fund typically spends more than half of the trading days in each year exposed to movements in the S&P 100 Index, albeit on a hedged basis. For the rest of the year, the Fund assumes a “risk-free” Treasury position and earns short-term money market rates of return as it seeks to protect capital during unfavorable market conditions for the SSC.
The key to switching between these stances boils down to a question of timing – and timing, in its various forms, is the principal source of alpha in this strategy…
As one might expect, consistently delivering positive performance across different market environments requires some adaptation. Bull markets of the sort seen in the late 1990’s (and even as recently as 2006) are ripe with entry and exit opportunities conducive to bull-spread investing. Conversely, bear markets characterised by negative momentum, skittish investor behaviour, and poor liquidity pose additional timing and trading challenges. Over the 17 years it has been in existence, Sentry has recognised and adapted to a number of these regime shifts.
For example, in the momentum and liquidity rich equity markets of 2006, Sentry accurately identified four major trend reversals during the year and implemented the SSC strategy around these periods of positive market directionality. Each of these four implementations lasted more than two months (longer than its long-run average holding of about four weeks). In contrast, weaker equity markets in 2007, characterised by relatively fewer periods of sustained positive market directionality (especially during the latter half of the year), meant that trading had to be more nimble and the SSC had to be constructed around shorter-term perceived trading opportunities. In fact, of the seven implementation cycles in 2007, all but one lasted fewer than four weeks.
Oh, to be able to construct and explain trades with the benefit of hindsight.
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