Two red flags: bias ratio and risk profile clearly pointed to the problems with Madoff

by Raphael Douady, Adil Abdulali & Ingmar Adleberg, 2009

The Madoff scandal continues to send tremors throughout the world of finance. Too many investors did not see any danger until it was too late. Perhaps the most striking is the fact that even among the funds claiming risk controls or quantitative processes, or even regulated funds, a few turned-out to be exposed to Madoff’s returns.

Even though some pointed to Madoff as a possible scam since the turn of the millennium too few investors listened. The Madoff situation clearly shines importance on two critical issues: the place for risk management in the investment process and the risk management techniques that can be used.

Numbers tell a story and clearly have an order that should be hard to fake. What appears to be too good to be true can be measured. Forensic accountants use Benford’s law to catch thieves. Analogously, anyone paying attention to quantitative advances in hedge fund risk management suspected that Madoff was a scam to be avoided. Amongst the quant techniques useful in detecting fraud, the most efficient is the Bias Ratio, invented by Adil Abdulali of Protégé Partners and available in Riskdata’s suite of analytics. In Madoff’s case, a calculation of the Bias Ratio points to the fallacy of Madoff’s returns. In addition, an accurate analysis of Madoff investment Risk Profile is inconsistent with its style and peer group.

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