SEC vs. Stanford: same return for two years – a red flag?

On February 17th, 2009 the SEC charged Stanford International Bank (SIB), R. Allen Stanford, et al with “a massive ongoing fraud.” Below are comments regarding potential challenges to SEC’s rationale and approach in supporting their case presented in the complaint on SEC website.

As shown in the excerpt below, the SEC points to SIB’s absolute performance vs. market indexes:

“Double-digit returns… over the past 15 years” which refers to the chart in Par. 28 of the complaint. Note that these are gross returns, while net returns paid to investors were about 8%. Many hedge funds generated higher after fees returns in 1992-2006. Plus, Stanford returns were high three and five years ago, so there must be something else.

Very suspicious performance in 2008: the fund lost “only” 1.3%. Guess what? So did a quarter of all hedge funds. According to the latest HFR data, 1318 hedge funds out of 5313 reporting lost less than Stanford in 2008. And so did about 12% of mutual funds (excluding money market).

Par. 4 of the complaint states that for SIB producing the same returns of 15.71% for two consecutive years 1995 and 1996 was “impossible” to achieve if Stanford have managed a “global diversified” portfolio of investments. Here’s the exact quote from the complaint:

So when did identical returns for two consecutive years become a red flag? This seems more a sign of transparent reporting. If someone were to concoct a fraud, the first thing they would do is to change at least one decimal to make it less suspicious! And by the way, what should be considered a red flag–is 1bp difference sufficient? How about 5bp difference?

First we should note that it is statistically “probable” and “possible” to obtain the same investment return for two consecutive years even when one is invested in liquid market instruments. Highly diversified portfolios would increase the probability. Diversification reduces volatility overall and aggregating volatile data into annual returns further reduces volatility. In addition, if underlying assets have similar performance during these years it increases the likelihood of the portfolio achieving similar results.

We ran a quick test and found about two dozen mutual funds and hedge funds having 1995 and 1996 returns within 10bp range. Note that these are only survivors and the number of actual funds that existed at that time could be easily 2-3 times higher. There are some identical matches in consecutive year performance and for many funds 1995-96 results are within 2-3 bp range.

So is it really a red flag? Well, not by itself based on the above considerations. Whether these numbers represent real returns and are not made up requires more sophisticated analysis such as returns-based (RBSA) and other quantitative due diligence methods.