Harry Markopolos is a well-known forensic accountant and former options trader who specialises in investigating financial fraud. He came to prominence when Bernie Madoff’s investment business was exposed as a giant Ponzi scheme back in 2009. Markopolos had warned regulators about Madoff as early as 2000, but went largely ignored.
In an interview with the Alpha Exchange podcast, Markopolos explained what it was about Madoff’s scheme that tipped him off.
Too good to be true
Markopolos first began to grow suspicious of Madoff’s wealth management business when he was tasked by his bosses at Rampart Investment Management - an options trading company - with trying to match the returns that Madoff was reporting. They had been approached by a client who was heavily in Madoff’s fund, and wanted to diversify their exposure with a different (but equally effective) strategy.
After digging around for a bit, he realized that these returns were mathematically impossible, and therefore must have been fraudulent. Bernard L Madoff Securities LLC was reporting net annual returns of 16%. What’s more, it was reporting very little volatility - its worst month on record only saw a drawdown of 55 basis points (0.55%). The supposed key to his success was the use of options and other financial derivatives. As an options trader himself, Markopolos knew full well that it would be impossible to achieve such high returns while at the same time keeping volatility this low:
“I knew within five minutes that it was a Ponzi scheme, because his returns were basically up at a 45 degree angle, and we don’t have 45 degree angles in finance! They exist in trigonometry, they might exist in physics, but not in finance. I wish I could say it was more complex than that, but it really wasn’t. The monthly returns were too steady - there was an absence of volatility. The Sharpe ratios were close to 3x. And how do you have that over a long period of time in finance? You might be able to dominate the markets short-term with a great trade that goes your way for a few months, or a year, but you can’t do it year after year after year.”
The Sharpe ratio measures the performance of a financial asset against a risk free asset (usually the rate offered on U.S. Treasuries), after adjusting for the risk of the financial asset. In a sense, it is a measure of how "good" an investor or trader is - a higher number indicates that they are earning more than you would expect from the risk they are taking on. In Madoff’s case, these numbers seemed way too good to be true.
Markopolos did also consider the possibility that Madoff was engaging in front running (illegally trading based on non-public information about an impending deal or trade), but eventually dismissed this possibility because Madoff’s firm was too big. The more assets one manages, the harder it is to front run, because the transactions required become too big to hide from regulators.
Additionally, the return on invested capital from front running will fall as the amount of money being managed increases because front running doesn’t really scale that well past a certain point. The fact that Madoff was always trying to bring in more assets was an indication that he probably wasn’t front running.
Investors can learn a lot about detecting fraud from Markopolos. Although he is undoubtedly an intelligent and talented financial investigator, none of the analysis that he did on Madoff’s scheme required any complicated mathematics or really deep thinking. So the next time that you see something that seems too good to be true, try to remember that it most probably is.
Disclosure: The author owns no stocks mentioned.
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