Many are drawing the wrong lessons on reversal from Bernie Madoff’s infamous career. Madoff, who died earlier this month, was the hedge fund manager who designed the largest Ponzi scheme in history. Many commentators are seizing the occasion of his passing to take part in what comes down to Monday morning’s quarterback, smugly insisting that if they had been given the opportunity to invest in his hedge fund in the passed, they would have known better. Their returns were too good to be true, they now say.
The reason this is the wrong lesson is that it goes too far. Sometimes an investment manager produces returns that seem too good to be true, but are nonetheless genuine. Perhaps the most famous example is Renaissance Technologies’ flagship hedge fund, the Medallion Fund. The Wall Street Journal reports that the fund produced an annualized net fee return of 39% over the 31 years to 2018. The fund has also been remarkably consistent: on a pre-commission basis, it has never had a losing year, and after. of fees, he hasn’t had one since 1989, when he lost 3.2%. To put that in context, Warren Buffett, CEO of Berkshire Hathaway BRK.A, + 0.72%, BRK.B, + 0.92% produced a return of “just” 15.5% annualized over this same period of 31 years. The S&P 500 SPX, + 1.09% return, including dividends, was 10.2%. At first glance, the Medallion Fund’s returns may seem too good to be true. But several statisticians I contacted told me that they appear to be genuine. One is Brad Cornell, emeritus professor of finance at UCLA. After reviewing Medallion’s history, he told me in an email: “The only conclusion I can come to is that there are cases where things seem too good to be true, but then turn out to be true.” So what is the right lesson to learn from Madoff’s “too good to be true” performance? For answers, I turned to Campbell Harvey, a finance professor at Duke University. He has the distinction of being able to say “I told you so” about Madoff’s record, as he warned others beforehand that there was something fishy about him. In an interview, he told me that many years ago he was hired as a consultant by a wealthy investor who was considering investing with Madoff. “It took me just five or 10 minutes to examine Madoff’s performance claims, in light of the strategy he said he was following, to learn that his track record was not credible.” The telling sign, Harvey explained, was the inconsistency between the inherent risk of the options strategy that Madoff said he was following and the extraordinary consistency of the returns he was reporting. Its reported “volatility was too low to be credible,” according to Harvey. Harvey’s Lesson: To judge whether a manager’s track record is credible, you need to look beyond the numbers themselves. Your due diligence involves analyzing the manager’s strategy in light of those numbers. It would be a red flag if you detect any inconsistencies between your reported returns and what you estimate your strategy should have produced, both in terms of gross returns and volatility. Certainly, you may not feel qualified to perform this due diligence. If so, find someone who is. What you pay them now can prevent you from paying dearly later. Mark Hulbert is a regular contributor to MarketWatch. Your Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org More: Prepare for $ 178 Billion in Sales Before Capital Gains Tax Increase. These are the stocks with the highest risk. Also read: The psychology of a stock bubble