“Muddy Waters” on Actual versus Nominal Losses

 

Often there is confusion in media reports on losses

So today I’m here with Muddy Waters to set the record straight.

Manufactured returns can overstate the actual loss investors have incurred.

Early reports were that investors in BLMIS (Bernard L. Madoff Investment Securities, LLC) potentially lost some US$ 65 billion based on the nominal value of their accounts.

Similarly, Wirecard was reported to have “lost” some Euros 1.9 billion in deposits.

In both cases, a lot of the initial speculation focused on alleged theft of the amounts.

But in both cases, the losses were overstated by the amount of manufactured returns.

In the case of Madoff, roughly US$ 19 billion df the US$65 billion was the original investment amount.

The rest US$ 46 billion was fictitious “profit”.

In the case of Wirecard, the Euros 1.9 billion in deposits arose because income was “fiddled” to a corresponding amount.

As Professor Waters (above) has rightly said:

Well, you know, you can't spend what you ain't got

You can't lose what you ain't never had

That doesn’t mean that investors in Madoff’s funds did not have a real loss.

Their loss was opportunity cost of not earning a return on their original investment.

No doubt lower than the US$ 46 billion, but still significant.

Adding insult to injury, the courts ruled that any Madoff investor who received a profit distribution (any amount in excess of the investor’s original investment) had to return it because it was “fictitious”. 

Here’s the US Court of Appeals Second District’s decision.

The US Supreme Court refused to hear the defendants’ appeal on 3 May 2020 (20-1382).

At stake was US$ 41 million.

You are capable of doing the math.

Not many of BLMIS “wise” investors were withdrawing their “profits”.

For Wirecard, the losses were to those lenders and stock investors that extended credit or bought Wirecard stock based on manufactured earnings. 

Unlike the BLMIS investors, the Wirecard "punters" are going to lose a much greater percentage of their original investment.

Baghban and Predecessors

 

Babuji and Pooja

Shūkichi and Tomi

Barkley and Lucy

Infinity Q Diversified Alpha Fund – "The Big Boys’ Market Revisited" or "A Fool and His Money"

It Would Appear
They Already Have the Shirt Off His Back

Julie Segal recently wrote in II that” Infinity Q’s Consistent Alpha Should Have Been a ‘Red Flag’”

There is an old saying in the world of finance that is usually ignored: 

If it looks to good to be true, it probably is.

There’s nothing like “profit” (real or manufactured) to dazzle even the biggest of the “big boys”. Or the promise of profit.

Or association with a perceived celebrity.

Here no doubt the breathless closing mantra from the sales pitch was:

These are the same guys who manage David B’s family office!

IQDA also had a “track record” of producing highly consistent excess returns (the “alpha” in its name). Beating its “benchmark” with regularity.

To employ a bit of understatement either of these feats are “extremely rare”.

To manage to do both rarer still.

And to do both consistently, in the realm of myth.

If it’s too good to be true, it probably is.

Yet, self-imagined sophisticated investors (the so-called “big boys”) fall for this over and over.

In part this is explained by the dazzle of outsized returns.

It explains the Dotcom boom, the 2008 Almost a Second Great Depression, Bernie Madoff, SPACS, Bitcoin, Tesla, etc.

And Hometown International the OTC-traded owner of a small NJ deli that attracted investments from prestigious universities! HI not the deli.

Celebrity connections play a role. Even if their financial knowledge is small. 

Think Dogecoin, Bitcoin.

Sometimes it can be a bit darker.

A belief that the fund manager’s success is based on less than legal methods, e.g., insider trading, rigged markets, corruption, etc.

And that it’s best not to inquire too closely lest one incur the legal obligation to “blow a whistle”. 

Or perhaps more accurately find oneself with unwanted legal “exposure”.

What makes the IQDA fund saga even more interesting is a typical attribution of returns analysis could not account for the stellar performance.

An attribution of returns analysis seeks to identify the factors (more on that below) responsible for total returns and their relative contribution to the total.

Here’s a quote from an MPI (Markov Process International) report.

In the case of Infinity Q Diversified Alpha, our [dynamic style analysis] suggests that the majority of the fund’s returns over the past 6+ years remain unexplained, quantitatively speaking,” MPI said in the report. “Reviewing these quantitative results would leave many advisors and analysts wondering ‘is this performance too good to be true? 

Here’s a link to more details on MPI’s analysis.

If time constraints mean you have to choose between continuing reading my post or reading MPI’s analysis, read theirs.

It is a brilliant demonstration of the sort of analysis that should be done.

Truly sophisticated investors (admittedly a small select group) and their professional advisors (a similarly small group) typically look behind the headline return and any return attribution provided by a fund.

They perform their own attribution analysis, isolating responsible “factors” and their contribution:

1. strategy/style, including drifts therein from what was promised

2. sector and individual asset selection

3. risk assumed

4. financial engineering as opposed to investment skills, e.g. leverage both direct and indirect (futures, options, etc)

They (should) also look for valuation engineering.

Where a fund’s performance is evaluated against a benchmark, one should determine that the benchmark is and remains appropriate.

Even more so, if the fund is compensated by “beating” the benchmark or a set hurdle rate. Think PE.

IQDA’s benchmark was the Credit Suisse Hedge Fund Index which reportedly follows the results of 9,000 hedge funds and asset weights their performances.

Is this an appropriate benchmark?

No.

There are significant differences in strategy among hedge funds: long-short, volatility convertible arbitrage to name just three. Leading to significant difference in their results.

Not all of the 9,000 hedge funds in the CSHFI have the same strategy or strategies. The creation of this index therefore “mashes together” the results of different strategies.

Therefore, it’s not meaningful to measure IQDA’s performance against it.

Would it be meaningful to compare the results of a (real) football player against a performance index composed of cricket, rugby, American football, Australian football, and tennis players?

There is no benchmark that fits IQDA.

CS is not the only provider of HF performance indexes.

Other FI’s provide them. Often with sub indices for a particular strategies.

These could be used to prepare more meaningful assessments of IQDA’s performance.

A related issue is valuation of assets – the other side of the “beating the benchmark”.

If asset value is inflated, the over performance (alpha) is as well.

That can occur from selection or tweaking of “inputs” into models. Or “adjusting” the models.

This is particularly the case where the strategies are based on complex hard to value instruments or transactions.  So called Tier 3 assets or transactions.

Absent clairvoyance, one would not be able to detect such fiddling.

But one can identify opportunities for fiddling. And that should be a sign to be vigilant. 

The MPI analysis shows how to do this quite quickly.

IQDA’s former CIO has been accused (but not convicted) of “playing” new tunes on the fund’s valuation model.

The “big boys” apparently didn’t perform their own attribution analysis and didn’t look at the appropriateness of the benchmark. 

Or use other HF sub index benchmarks to analyze performance.  

Or hire a qualified firm to do it for them.

Perhaps they did and then ignored the results.

I’d like to be able to categorically discount that possibility. 

But sadly I have seen the most egregious behaviour during my storied career.

With IDQA the “big boys” appear little different from retail investors, except of course for the amounts of money they could throw at their delusions.

History suggests that this was not a one-off aberration.