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Why so many smart investors bought into Madoff.

Today, I was looking into a few large-cap stocks to trade, and came up with a one-shot almost risk-free way to make 10% on one’s money in two months. After I was done, I realized that it was the same thing as a “split-strike trade” wherein you combine a stock and two option trades to make the down-side a fifth of the upside. The whole “strategy” was valid for five minutes – the market adjusted to remove this inconsistency before I could place a trade.

If you are a large market maker, with access to instant efficient execution of trades, yes – you can occassionally make money using a split-strike strategy. For starters, one needs to be a non-newbie investor to even understand this strategy on paper. A more sophisticated investor *knows* that money can be made using this strategy. Throw in the operations of one of the larger market makers, and it is easy to take the next logical mental step that one could consistently churn out positive returns in the market. Add to this a whisper campaign that you are front-running your order queue, and an even further sophisticated the investor, the higher the chances are that you can actually place a value on front-running the market.

Here are the kinds of investors that Madoff hooked.

Type #1. The rich newbie. Daddy told him/her that he had a secret account that churned out a percent a month like clockwork, and that noob could not share this information with anyone else. Noob gets into the club, and has been seeing 1% returns every month like clockwork for the past decade.

Investing mistake: Know how your $ is invested. Just the fact that it made money in the past means nothing.

Type #2. Richer still than #1 above, but still ignorant about investing. This one looks at noob’s statements and the fact that it goes back by a decade, and decides to go “all in”. If he/she felt they were “not rich enough”, they recruited their family to invest in this absolutely secret hedge fund where you got rich slowly – without taking any risk.

Investing mistake: While #1 is “knowledgeable” about investing, but I [#2] know more than he/she does, and want into what #1 has……. Just because your neighbour is into something, it does not make that strategy appropriate for you as an investor.

Type #3. The guy who knows about investing, knows about stocks, and options, and can actually figure out what a split-strike strategy is. Well, this kind knows all about the strategy that Madoff used. He/she thinks they are smart [and probably is]. Knows a lot, but not enough to conquer the snake that Bernie was.

Investing mistake: Sophisticated, but not sophisticated enough. While #3 might know about stocks and options, he/she is ignorant about the size and frequency of possible trades of this nature. In other words, #3 knows about sophisticated trading, but is not aware of [or even wants to know about how large it is] the scalability of his sophisticated strategy.

Type #4. The sophisticated snake. This investor knew exactly how large the size of the option trading market was, and that Bernie was “too big” to pull off what he claimed to be doing. This investor was aware that Bernie had to pull of his strategy multiple times a month to churn the billions that he managed. In fact, investor #4 knew for sure that Bernie had to front-run the order queue to make money. In other words, sophisticated snake knew that Madoff was cheating, but “nobody got hurt”, and we the secret society of sophisticated snakes were making money for tens of years without getting caught. Why spoil a good thing?

Investing mistake: Made an assumption without knowing what the real trading strategy was. Sophisticated snake was smart enough to know Bernie was cheating, but was unaware of how exactly he was pulling off his act. But it did not matter as long as #4′s secret society made money – even at the expense of the generally stupid trading public [and mutual funds and other ordinary investors]. In other words, investor Type #4 was smart, and that is exactly the reason he/she was “taken” by Bernie.

Type #5. The Distributor. This investor started out cautiously, and created a “feeder fund”. Got some of his wealthiest and best friends into this deal mostly for the initial 1% commission. But as time passed by and one year became a decade, it was time the distributor went “all in”.

Investing mistake: The distributor was a sophisticated investor. He was initially enticed solely by the fact that he could make a living getting people to invest in this steady 1% a month deal. After a decade, Type #5 determines that he has “lost” millions by not getting into the same funds himself.

Type #6. The foreign Aristocrat. His blood is blue and he knows it. But he is modest [but for his yachts and Rolexes and Ferrarri's]. Has a deep sense of responsibility and audits every word and every punctuation of every document, and determines that this investment is suitable for royalty [and neo-rich too].

Investing mistake: He/she knows the theory of investing, and thinks that the SEC is there to protect him, and that every rule has to be observed. But is clueless that his best friend is actually a low-life in a bespoke suit. Type #6 never saw anyone like Bernie in the “old world”.

Type #7. Cannon fodder. Type #7 was a sophisticated investor who was out skiing in Verbier. He/she meets this Russian Oligarch who orders $5000 cocktails and stays in the $50K a week chalet. #7 *knows* that he/she is infinitely superior to the Oligarch, but knows that the Oligarch hangs out with other Oligarchs and that Oligarchs really want to be Tsars. So, #7 incorporates a small bank with a name associated with royalty, the Pope and God, and paints him/herself as “old money”. Oligarch “invests” with #7 and soon, all of the nickel and oil is Russia is Bernie’s – through #7.

Investing mistake: Type #7 is clueless. Just wants the money. Oligarchs want him/her dead. NOW.

© Bapcha’s Stocks 2009.

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