Ed Thorp: Ahead of the curve
Uncovering the Madoff ponzi scheme before the fall
For those of you who cannot recognise the person in this picture this is Bernie Madoff. He is an American financier who had run the largest Ponzi scheme in history amounting to close to $65 billion.
“At some point, Madoff attracted investors by claiming to generate large, steady returns through an investing strategy called split-strike conversion, a legitimate trading strategy.
What Madoff was really doing was depositing client funds into a single bank account that he used to pay existing clients who wanted to cash out. He funded the redemptions by attracting new investors and their capital. This is the classic Ponzi scheme model: Take in a constant stream of new money while paying enough back to maintain the appearance of outsized gains.
Inevitably, the fraud unraveled when the market turned sharply lower in late 2008 and too many clients sought to withdraw their money.
On Dec. 10, 2008, he confessed his wrongdoing to his sons—who worked at his firm. The following day, they turned him over to the authorities. Bernie remained adamant that his sons and his wife were not aware of his scheme.
The fund's last statements indicated it had $64.8 billion in client assets.”- Investopedia.
Till the time he went bust many people used to get stable returns month in month out. It almost seemed like he had given his investors a rate of return which was guaranteed as he had done this since the 1990’s.
Bernie Madoff was a legend before his ponzi scheme was busted. While he was this legend one person advised Mckinsey to remove their money in the late 90’s itself as he said it was a fraud and he said it would all come falling down.
Ed thorp a mathematician, gambler and investor had figured out that Bernie Madoff’ returns which were being generated were not real.
You can watch him explain how he found out in 1991 here.
Discovery
In 1991 he was invited to review the portfolio of Mckinsey and co. in New york. While looking at their investments one particular investment caught his eye. It was something very strange, it kept giving 1-2% return every single month for years. Naturally seeing this Ed thorp asked them how this was possible. They did not know how the returns were made but could show him the accounts.
He saw the accounts. The account had a trading strategy which involved hedging their investments. But their strategy according to Ed thorp would end up having down months. So Ed thorp decided to check what the trades were like in months were the index was down. It turns out that in the down months there was a miraculous trade that made them get a return of 1-2% every single month. These trades were in the S&P index options and they were made in the right time and were right every single time.
Naturally he wanted to look into this deeper because this was too good to be true. So he wanted to meet the people in charge. The person he was going to meet was Bernie Madoff’s brother Peter Madoff as Bernie was in Europe raising more money, but he was not allowed to enter his office.
Thorp knew that this was a scam already but he needed something which confirmed his hunch or a smoking gun.
So Thorpe decided he would check the data that was provided by the accountants with the exchange and he noticed that it was not possible that the trades have occurred. There was a mismatch with the data provided by the exchange and the accounts of Madoff. He then ended up asking someone at Bear sterns whether they had sold some option contracts to Madoff and they checked and they had never traded with Madoff.
Thorp knew for sure now that this was a ponzi scheme and it would all come falling down.
He went to Mckinsey and told them that this is a ponzi schem and they should remove their money immediately. He told them that this is a fraud and the trades are fake. Mckinsey of course hesitated. They were making 20% on their investment why would they remove it?
At the time their other investments were making about 16% return and Ed thorp told them if I am right and you don’t remove your money at some point you will end up losing your jobs as this fiasco ends and if he was wrong they would make a 16% return instead of 20.
To quote him word for word, “If I’m right, the roof’s going to fall in some day, and you might lose your jobs.”
Mckinsey ended up removing their investment and they did so quietly. What is interesting to me is that Ed thorp knew that all these returns were not real yet he did not tell the SEC.
“Thorp decided against approaching regulators and sharing his evidence. He had just shut down his hedge fund after Rudy Giuliani had come after him and his partners using the RICO act. Thorp was in no mood to work with the government. He also claimed that a friend and former SEC staffer told him it would be a “waste of time” to report Madoff. The agency didn’t care. He remained quiet, warned people in his network, and waited “year after year after year” for the blowup. In 2008, he was finally proven right.”- Frederik gieschen
After discovering that he is fraudulent he informed everyone in his network and told them the roof would fall. One of his close friends chose to ignore the information he had and stuck with Madoff right till the end. He asked his other friends and they all thought that Madoff was legit.
It is so hard to be right but proven to be right after a long time. People who made money ignored him because according to most people he was an ‘investment genius’. This is probably because he made them a ton of money.
““The crowd voted for investment genius,” Thorp explained, “and got it wrong.” He called it the “lunacy of lemmings.” Thorp was immune to the lunacy because of what he called his ‘inner compass.’ (what Buffett would call an ‘inner scorecard’). Thorp believes that many people lack this inner clarity and look to others for “cues about what to do and how to behave” — they find themselves adrift in life. Eventually, they run aground. If you study Thorp’s life, you find a strong inner compass at work.”- Frederik gieschen
Ed thorp is a super investor and a genius. He was one of those people who always thought in probabilities and there is a lot to learn from him. One more really interesting thing about him is his health. He is in amazing shape and is 92 years old. If you see him you will think he just touched 60. Other than market and gambling there is a lot to learn about health from him as well.
References:
Ed Thorp: Survival of the Fittest Mind
Bernie Madoff: Who He Was and How His Ponzi Scheme Worked
Thank you for reading,
Samvit.