Lessons from the Best Performing Hedge Fund in the World

In the Zurich database of 41 funds with track records that extends from July 1989 to Feb 2001, there was one American fund that stood head and shoulders above the rest with the best performance on a risk-adjusted basis.

In addition, over the past 139 consecutive months ended May 2001, the fund generated clockwork-like gross returns just north of 1.5% per month, and annualised net returns that were very close to 15%.

It sure seems like the fund has hit upon the holy-grail of investing – achieving consistently high returns in the stock market. To realise just how difficult that is, here’s how the American stock market, as represented by the S&P 500 Index, performed from 1989 to 2001.

Year Annual Return
1989 30.7%
1990 -9.20%
1991 27.8%
1992 4.30%
1993 6.90%
1994 -1.40%
1995 35.2%
1996 18.7%
1997 32.3%
1998 26.0%
1999 18.5%
2000 -11.8%
2001 -10.0%

Source: S&P Capital IQ

Notice how volatile those returns have been? Even other great money managers – folks like Warren Buffett, John Neff, Peter Lynch, Walter Schloss etc. – suffered volatile returns in their decades-long investing careers. How did the manager of the fund in question achieve such precise returns year-in and year-out for more than 11 years?

The madness to the method

One word: Fraud

You see, the fund in question was Bernie Madoff’s Fairfield Sentry fund and those statistics I mentioned came from a great profile of Madoff, written by Michael Orcant, that was published in May 2001 (some seven years before Madoff was arrested for fraud) by hedge fund publication MARHedge. I was alerted to Orcant’s article by my American colleague John Reeve’s piece on the con man Madoff.

Turns out, Madoff’s fund operated like a classic Ponzi scheme. He used money coming in from new investors to pay-off the promised-returns for old investors. The whole operation collapsed in 2008 when Maddoff faced huge redemptions of up to US$7b due to the then on-going financial crisis.

Unsurprisingly, he had trouble meeting those redemptions as he did not really have any real securities to sell to raise funds (most of the cash his ‘fund’ took in all this while was used to pay out to earlier investors). He was eventually arrested and charged by US authorities for securities fraud in Dec 2008.

Prior to that however, he had tried to convince investors that he was using a rather complex investment process called a split-strike conversion strategy. It’s described by Orcant as “buying a basket of stocks closely correlated to an index, while concurrently selling out-of-the-money call options on the index and buying out-of-the-money put options on the index.”

While other professionals who have used similar strategies in the past did not even come close to Madoff’s performance, investors trusted him implicitly due to his storied history within the securities industry. Alas… it all turned out to be a house of cards.

I have always found Madoff’s story to be fascinating and here are two key takeaways for investors about the whole saga.

1. If something is too good to be true, it usually is

Madoff claimed to be operating in the stock market, but yet managed to roll out astonishingly consistent returns that were clearly incompatible with how volatile the financial markets can be.

Even in Singapore, the stock market here, as measured by the Straits Times Index (SGX: ^STI), can also experience wild annual swings. Here’s what I had written previously on the topic: “…in 25 full calendar-years [from 1988 to 2012], the STI has declined from its annual-peak to its subsequent-trough by more than 20% in eight separate years. That’s almost one-third of the time and yet market participants anecdotally find out that their stomachs start churning even at 10% pullbacks!

The financial markets are just inherently volatile and any investor claiming to be able to generate clockwork-like returns should be subjected to close scrutiny.

In fact, with the majority of investment “schemes”, the idea of being able to get consistent returns year-in year-out is a big draw for most. But, this particular age-old adage generally holds up well too: “If something is too good to be true, it usually is.”

2. It does not take complicated investment strategies to win the investing game

The split-strike conversion strategy that Madoff claimed he used sounded awfully complex to me. It might even be possible that he choose that as a front for his Ponzi scheme because it is complex enough; complex enough to awe and intimidate new and less sophisticated investors.

But the thing is, it does not take complicated investing strategies to generate superior long-term investing results.

Just take Edgerton Welch. His mutual fund (equivalent of a unit-trust here) was the best performing fund in the USA in the 11 years ended 1981 and he followed the simplest of investing strategies: He only bought stocks that were highly regarded by Value Line, a financial publication, and two brokerage firms that he trusted.

Here’s more. The Goldman Sachs Rising Dividend Growth Fund has delivered market-beating annual returns of 8.71% a year compared to the S&P 500’s 7.51% over the past nine-plus years from March 2004 to Nov 2013. It achieved that by selecting shares on two very simple criteria: 1) consistently growing dividends over the past 10 years; and 2) annual growth rate for dividends in excess of 10%. That was it.

Foolish Bottom Line

Simple often can win in investing, but patience and reasonable expectations are often needed. Want to make big returns in the stock market, but refuse to accept its inherent volatility? Bernie Madoff might be the man for you.

On the other hand, if you’re looking to build lasting long-term wealth by investing in fundamentally sound business with solid long-term prospects at reasonable prices, then hey, you are on to something there.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.