Harry Markopolos: The World Largest Hedge Fund is a Fraud

Harr Markopolos wrote a 19 page document to SEC discussing why he believes that Bernie Madoff is a fraudster. It can be found here.

It is a really interesting read. Basically, it is quite hard to believe that SEC didn't buy this. He puts out a plethora of arguments, some interesting, some obvious (even to me!) about why Madoff's fund is a fishy. Basically, Madoff claimed to have been using the so called split-strike conversion. This is a simple strategy, where you buy a portfolio of stocks and prevent losses associated with downward motion of these stocks by buying out of money put options on some index correlated with your stocks. You pay this protection by selling out of money call options. In other words, if nothing happens you get the profit on the mean growth and you protect yourself against large losses by forfeiting large gains. So, why is Madoff a fraudster?
Harry puts out many, many reasons, but most interesting are:

• The size of the entire market for these options on regulated markets is not enough to cover hist investments, neither for call, nor for put. Why would he be buying such vanilla options over the counter and pay extra for them?
  
• He had virtually not losses over 20 years. Now, to avoid this, he would have to been buying at the money options, rather than out of the money options and the sums don't add up - there is no way he could keep such profits while still paying for these super-expensive options.
• Nobody else following this strategy was able to do much better than treasury bills + 1 percent or so.
• There was absolutelly no correlation between market movements and Madoff's returns. Since he is buying a real portfolio of stocks, but insuring only on indices, this is mathematically impossible!
  
• Taking private money and returning it with 12% interest to run his strategy is stupid. Why wouldn't he borrow at LIBOR+something rates?
• He unwinds all his investment always at the right time, just before market crashes.

There are many less technical resons to do with secrecy, avoidance of anythign regulatory, etc. But the best bit is Harry's style. He writes as if SEC and himself were good friends, chatting about Madoff over a beer. Sentences like "Leon is a free spirit and if you ask him he'll tell you but you'd understand better if you meet him in a private room...". A really fascinating read!