No One Would Listen: A True Financial Thriller by Harry Markopolos (i wanna iguana read aloud .txt) 📕

income from the stock’s dividends. Let’s attribute a 2% average return to this source of funds for the 14½ year time period. This explains 2% of the 16% average gross annual returns before fees and leaves 14% of the returns unexplained.

2. We earn income from the sale of OTC OEX index call options. Let’s also assume that we can generate an additional 2% annual return via the sale of OTC out-of-the-money OEX index call options which leaves 12% of the 16% gross returns unexplained. On Friday, October 14, 2005 the OEX (S&P 100) index closed at 550.49 and there were only 163,809 OEX index call option contracts outstanding (termed the “open interest”). 163,809 call option calls outstanding x $100 contact multiplier x 550.49 index closing price = $9,017,521,641 in stock equivalents hedged.

3. We can earn income from capital gains by selling the stocks that go up in price. This portion of the return stream would have to earn the lion’s share of the hedge fund strategy’s returns. We have 12% of the return stream unexplained so far. However, the OTC OEX index puts that we buy will cost AT LEAST <8%> per year (a lot more in most years but I’m giving BM the benefit of every doubt here). Therefore, BM’s stock selection would have to be earning an average of 20% per year. That would mean that he’s been the world’s best stock-picker since 1990 beating out such luminaries as Warren Buffet and Bill Miller. Yet no one’s ever heard of BM as being a stock-picker, much less the world’s best stock-picker. Why isn’t he famous if he was able to earn 20% average annual returns?

Red Flag # 4: $9.017 billion in total OEX listed call options outstanding is not nearly enough to generate income on BM’s total amount of assets under management which I estimate to range between $20-$50 billion. Fairfield Sentry Ltd. alone has $5.1 billion with BM. And, while BM may say he only uses Over-the-Counter (OTC) index options, there is no way that this is possible. The OTC market should never be several times larger than the exchange listed market for this type of plain vanilla derivative.

B. Protection Part of the strategy is to buy out-of-the-money OEX index put options. This costs you money each and every month. This hurts your returns and is the main reason why BM’s strategy would have trouble earning 0% average annual returns much less the 12% net returns stated in Fairfield Sentry Ltd.’s performance summary. Even if BM earns a 4% return from the combination of 2% stock dividends and 2% from the sale of call options, the cost of the puts would put this strategy in the red year in and year out. No way he can possibly be delivering 12% net to investors. The math just doesn’t support this strategy if he’s really buying index put options.

Red Flag # 5: BM would need to be purchasing at-the-money put options because he has only 7 small monthly losses in the past 14½ years. His largest monthly loss is only <0.55%>, so his puts would have to be at-the-money. At-the-money put options are very, very expensive. A one-year at-the-money put option would cost you <8%> or more, depending upon the market’s volatility. And <8%> would be a cheap price to pay in many of the past 14½ years for put protection!! Assuming BM only paid <8%> per year in put protection, and assuming he can earn +2% from stock dividends plus another +2% from call option sales, he’s still under-water <4%> performance wise. <8%> put cost + 2% stock dividends + 2% income from call sales = <4%>. And, I’ve proven that BM would need to be earning at least 16% annually to deliver 12% after fees to investors. That means the rest of his returns would have to be coming from stock selection where he picked and sold winning stocks to include in his 35-stock basket of large-cap names. Lots of luck doing that during the past stock market crises like 1997’s Asian Currency Crises, the 1998 Russian Debt / LTCM crises, and the 2000-2002 killer bear market. And index put option protection was a lot more expensive during these crises periods than 8%. Mathematically none of BM’s returns listed in Attachment 1 make much sense. They are just too unbelievably good to be true.

C. The OEX index (S&P 100) closed at 550.49 on Friday, October 14, 2005 meaning that each put option hedged $55,049 dollars worth of stock ($100 contract multiplier x 550.49 OEX closing index price = $55,049 in stock hedged). As of that same date, the total open interest for OEX index put options was 307,176 contracts meaning that a total of $16,909,731,624 in stock was being hedged by the use of OEX index puts (307,176 total put contracts in existence as of Oct 14th x $55,049 hedge value of 1 OEX index put = $16,909,731,624 in stock hedged). Note: I excluded a few thousand OEX LEAP index put options from my calculations because these are long-term options and not relevant for a split-strike conversion strategy such as BM’s.

Red Flag # 6:At my best guess level of BM’s assets under management of $30 billion, or even at my low end estimate of $20 billion in assets under management, BM would have to be over 100% of the total OEX put option contract open interest in order to hedge his stock holdings as depicted in the third party hedge funds marketing literature. In other words, there are not enough index option put contracts in existence to hedge the way BM says he is hedging! And there is no way the OTC market is bigger than the exchange listed market for plain vanilla S&P 100 index put options.

D. Mathematically I have proven that BM cannot be hedging using listed index put and call options. One hedge fund FOF has told me that BM uses only Over-the-Counter options and trades exclusively thru UBS and Merrill Lynch. I have