Exploiting a Loophole to Gain Outsized Returns

Some people have found a way to beat the market without taking on unacceptable risk.

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I believe in the efficient markets hypothesis, which holds that new, publicly-available information is immediately incorporated into the price of a stock or bond. Burton Malkiel, the author of A Random Walk Down Wall Street, observed that despite intensive efforts to find predictable patterns or anomalies, many of the patterns disappear soon after being discovered, leaving little room for the most adept investor to benefit from them.

The ramifications of the efficient market hypothesis are profound. If you accept that markets are random and efficient, predictions about the future direction of the market should be ignored. Efforts to research stocks and bonds, in order to find mispricing, should be abandoned as futile.

It’s difficult for many investors to accept the teachings of Malkiel and others who have spent their lives studying the capital markets and publishing their research in peer-reviewed journals. Most of the securities industry is premised on the opposite view: Persuading you they have the ability to engage in market timing, stock picking, and fund manager selection. Ironically, few of those purporting to have this expertise have legitimate credentials, and even fewer have subjected their views to scrutiny by respected journals.

It was therefore surprising when I reached the conclusion there is a way to game the system, notwithstanding the efficiency of the markets, and achieve outsize returns. My inspiration came from an unlikely source: Peter Madoff, the brother of disgraced swindler, Bernard Madoff, who is currently serving a 150-year sentence for running a massive Ponzi scheme.

Peter Madoff, an attorney by training, served as chief compliance officer at his brother’s firm. He admitted to falsifying documents, lying to securities regulators, and filing sham tax returns, and was sentenced to ten years in prison.

He denied knowing anything about Bernard’s Ponzi scheme, which he claims he learned of shortly before Bernard was arrested. His contention is the key to understanding the loophole.

For acting as chief compliance officer, Peter was rewarded handsomely. He earned about $40 million in the decade beginning in 1998 and lived a lavish lifestyle. According to one survey, the average compensation for chief compliance officers is $125,000, a fraction of Peter Madoff’s salary. Judge Laura Taylor, who sentenced Peter Madoff, found his claim of ignorance to be “not believable.”

That’s when I had my epiphany. Any student of the market knows that steady returns, year after year, regardless of market conditions, are virtually impossible. No legitimate, audited mutual fund had ever reported the returns claimed by Bernard Madoff. Surely, some of the investors in these funds knew Bernard Madoff was engaged in some kind of illegal activity, but elected to invest with him anyway, because they thought they were getting steady returns, without taking meaningful risk.

The recent spate of insider trading convictions and indictments indicates other investors may be exploiting the same loophole. They believe some hedge funds may be achieving stellar returns by using illegal, inside information, but they don’t care because they are only focused on returns. They also correctly believe there is no risk of prosecution in doing so. They don’t know illegal activity is taking place. It’s just a suspicion. If anyone questions them, they can always use Peter Madoff’s denials as a defense.

Now you have a way to “beat the market”, without taking unacceptable risk. The consummate greed of the securities industry shows no sign of abating. Not even the threat of meaningful prison terms seems to deter them. If you have flexible ethics, there’s no shortage of opportunities.

As convicted hedge fund manager Raj Rajaratnam famously stated in a wiretapped conversation: “Bring it on baby.”

Dan Solin is a senior vice president of Index Funds Advisors. He is a New York Times best selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now: How to Defend Yourself Against Rigged Markets, Wall Street Greed, and the Threat of Financial Collapse, will be published on December 31, 2012.

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