How hedge fund fraudster Bernie Madoff Marketed His Fund and Pulled off Biggest Ponzi Scheme.
Hedge fund fraudster Bernie Madoff was a “master marketer,” and his fund was considered exclusive, giving the appearance of a “velvet rope.”
He generally refused to meet directly with investors, which gave him an “Oz” aura and increased the allure of the investment.
Rather than offer high returns to all comers, Madoff offered modest but steady returns to an exclusive clientele. The investment method was marketed as “too complicated for outsiders to understand.” He was secretive about the firm’s business, and kept his financial statements closely guarded.
Madoff “worked the so-called ‘Jewish circuit’ of well-heeled Jews he met at country clubs on Long Island and in Palm Beach.”
One of the most prominent promoters was J. Ezra Merkin, whose fund Ascot Partners steered $1.8 billion towards Madoff’s firm.
Some Madoff investors were wary of removing their money from his fund, in case they could not get back in later.
Madoff’s annual returns were “unusually consistent,” around 10%, and were a key factor in perpetuating the fraud.
Ponzi schemes typically pay returns of 20% or higher, and collapse quickly. One Madoff fund, which described its “strategy” as focusing on shares in the Standard & Poor’s 100-stock index, reported a 10.5% annual return during the previous 17 years. Even at the end of November 2008, amid a general market collapse, the same fund reported that it was up 5.6%, while the same year-to-date total return on the S&P 500-stock index had been negative 38%.
An unnamed investor remarked, “The returns were just amazing and we trusted this guy for decades — if you wanted to take money out, you always got your check in a few days.
The Swiss bank, Union Bancaire Privée, explained that because of Madoff’s huge volume as a broker-dealer, the bank believed he had a perceived edge on the market because his trades were timed well, suggesting they believed he was front running.
Madoff’s sales pitch was an investment strategy consisting of purchasing blue-chip stocks and taking options contracts on them, sometimes called a split-strike conversion or a collar.
“Typically, a position will consist of the ownership of 30–35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money ‘calls’ on the index and the purchase of out-of-the-money ‘puts’ on the index. The sale of the ‘calls’ is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the ‘calls’. The ‘puts’, funded in large part by the sales of the ‘calls’, limit the portfolio’s downside.”
In his 1992, “Avellino and Bienes” interview Madoff discussed his supposed methods: In the 1970s, he had placed invested funds in “convertible arbitrage positions in large-cap stocks, with promised investment returns of 18% to 20%”, and in 1982, he began using futures contracts on the stock index, and then placed put options on futures during the 1987 stock market crash.
Mitchell Zuckoff, author of Ponzi’s Scheme: The True Story of a Financial Legend, says that “the 5% payout rule”, a federal law requiring private foundations to pay out 5% of their funds each year, allowed Madoff’s Ponzi scheme to go undetected for a long period since he managed money mainly for charities. Zuckoff notes, “For every $1 billion in foundation investment, Madoff was effectively on the hook for about $50 million in withdrawals a year. If he was not making real investments, at that rate the principal would last 20 years. By targeting charities, Madoff could avoid the threat of sudden or unexpected withdrawals.
In his guilty plea, Madoff admitted that he hadn’t actually traded since the early 1990s, and all of his returns since then had been fabricated.
Madoff’s operation differed from a typical Ponzi scheme. While most Ponzis are based on nonexistent businesses, Madoff’s brokerage operation was very real.