Monday, December 29, 2008

Madoff's Strategy - As I Understand It
From what I have been able to gather from reading news reports on Bernie Madoff and watching CNBC, it appears that Madoff was managing money based on a strategy using options on an index. He would buy a stock or index, sell a call option and buy a put option. For example, he would:
  • Buy the underlying stock at $100
  • Sell a call option at $105, giving the buyer of the option to purchase the stock if it reached $105
  • Buy a put option at $95, giving Madoff the option to sell the stock if it dropped below $95
What this strategy, known as a collar, did was limit the upside because the stock would get "called" if it reached $105, and protect the downside because if the stock dropped below $95 the put option would be exercised and the stock would be sold at $95 no matter how much below this amount the stock had fallen. The money received for selling the call option should have offset the cost of buying the put option. This collar strategy is generally benign, as it limits gains and losses to the range between the exercise price between the two options. Success is through repetition of the process over many stocks and having the underlying stocks increase in value slowly.

This strategy is marketed to conservative investors. It is usually only successful when markets are rising slowly and orderly (so the stock does not get called away or the put option exercised), which rarely happens. Consistent, long-term returns are hard to achieve because winning positions tend to be offset by losing positions.

A mutual fund group called Kelmoore has run a similar option strategy and has posted poor returns. I remember this fund group from the late 1990s when its funds came out at $10 per share. Financial advisors at the brokerage firm I worked for screamed for these funds because of their alleged safe, solid investment strategy. Over the several years that I followed the funds, shares in various Kelmoore funds dropped to less than $5 per share. Bad returns for a conservative strategy.

I searched for updated data on the Kelmoore funds. I found limited information on a few financial websites. It looks like the Kelmoore funds had some kind of reverse stock split in 2005, and continued their losing ways. The Kelmoore funds were acquired or taken over by another fund company, Dunham, earlier this year and have slipped into obscurity. Here is a chart of one Kelmoore fund's performance:

Ouch. It looks like the original $10 investment has lost nearly 90% of its value. This strategy is also a tax disaster as all gains and income are short-term. So you lose money and get a tax bill.

I don't know how similar this is to what Madoff was doing, but it could not have been that much different, especially since Madoff's bogus black box strategy was a fraud, and his consistent returns a lie. The simple rule is avoid people selling "safe" covered call strategies.


Johnnyray said...

Kelmoore isn't the best example of the Madoff strategy. A better example (named in the letter to the SEC in 2007) is the Gateway Fund.

Kelmoore sold individual calls on the underline equities (then paid it out in a monthly distribution. Your return numbers do not include the distributions that the fund sent to the shareholders, so they are a little misleading) while Gateway and Maddoff strategy mirrors an index, then sell index calls and purchase index puts.

If you look at the performance of the Gateway fund, you can see that there are benefits from writing covered options, namely volatility reduction, but you can also enhance income.

I don't think the strategy should be under focus, more the fact that Madoff was his own Broker Dealer, Clearer, and auditor. Madoff is the same, not covered option writing.

Take care.

Rational Realist said...

Thanks for the information. I will check out the Gateway Fund.