The Madoff Dilemma

The key concept here, developed by MIT professor and noted hedge-fund theorist Andrew Lo, is "serial correlation." Simply put, serial correlation is the degree to which each month's returns in a fund mirror the results of the month before. A fund that returns the exact same amount every month is perfectly serially correlated. Madoff's returns were strikingly consistent month after month, year in and year out. That kind of performance—a nice, smooth line going up no matter what the market does—is a really good sign that you should look more closely.

The extraordinary thing that Lo does in the third chapter of his book Hedge Funds, published earlier this year, is to demonstrate mathematically that an excessive degree of serial correlation is a powerful indicator that the holdings of a fund aren't being reported realistically. What Lo shows from the pattern of historical returns in hedge-fund databases is that when funds' returns grow too consistent, it is a sign that the investments are either very hard to value accurately and the returns are just guesses, or, worse, that they've been manipulated in a way that smoothes them artificially. What Lo creates is a mathematical model for judging what "looks too good to be true." Lo's work turns a lot of the conventional thinking about what's safe on its head. It shows that the evenness that investors have traditionally been taught indicates safety and reliability can actually be the best sign risk is being hidden or that the data are unreliable.

Is excessive serial correlation a definitive measure of how suspicious you should be of a fund manager? No. Very smooth returns won't prove anything about a particular fund. And they don't indicate anything about some kinds of very safe investments: If your bank CD returns the same 3 percent every year—well, that's OK, nothing unusual there. But if a stock-fund manager shows the same 1 percent increases month after month, watch out. There are exceptional fund managers out there. Though decades of experience show it's very hard to beat the market, some manage it. But the ones who can do so almost invariably—it's hard to resist the baseball analogies so loved by stock market writers, so this time we'll give in—with some home runs and strikeouts. They don't hit doubles every time they go up to the plate. If they do, it's time to watch the slow-motion replay.

Andrew Lo's work, while it's the latest thinking in the field, is well-known to the fund-management experts on Wall Street—though not as well-known to the public as some other headline-making economists. If Madoff had billions of dollars from just a handful of investors, some of them should have had the know-how to spot what was wrong. When things are going well, however, investors rarely want to look at the results too closely. It's only when they ask to take out money that's no longer there that they find out what was going on.

The Madoff story is a bit of an anomaly in that, if what's in the criminal complaint is even close to accurate, he fessed up to what was going on before the government came looking for an indictment. It's early to speculate about what might have motivated him, but it's a fair bet that protecting his sons, who ran the business with him, from prosecution would be high on the list of concerns. Whoever is next probably won't volunteer so much so readily, preferring the more conventional approach of letting the game play out to the bitter end and then denying everything.

You can bet that right now, though, major investors are scrambling to crunch the numbers on other boutique managers. One thing that almost everyone on Wall Street has had drummed into them is that bad news is, in Wall Street lingo, "highly correlated": It tends to come in clusters and bunches. If one investment manager's holdings can go from $17 billion to zero overnight, it's likely there are several more multibillion-dollar blowups just waiting to rear their heads.

© 2008