The 8 billion dollar gamble

The 8 billion dollar gamble - roulette wheel image for article by Greg Alder

Lots of people like to gamble. Most people who gamble do so with their own money. Some prefer to gamble with other people’s money.

This is the story of Advanced Investment Management.

In March 2002, the ten-year-old investment advice and commodity trading company had US$8.5 billion of client money under management.

By August 2002, they had whittled that down to US$500 million.

By December 2002, AIM had shut their doors.

How do you lose eight billion dollars in a few months? Well, the story goes like this –

AIM offered its clients a sophisticated product called Enhanced Indexing. The goal of this product was to deliver returns that exceeded the S&P 500. AIM did this by using derivatives. These ‘synthetic’ investment products allowed AIM to build portfolios for their clients at a cost of about 5% of what it would have cost to invest in the S&P500 equities themselves.

AIM then used the remainder of their clients’ money to make short-term, high quality investments that would help them outperform the S&P 500 by 70 to 125 basis points (0.7% to 1.25%) annually.

Under the terms of agreement with each of their clients, AIM was to maintain 100% market exposure. This meant that a client’s exposure to the vagaries of the market was minimised because the market value of each client’s portfolio moved parallel with the S&P 500.

So far, so good.

Now AIM also had some more aggressive clients who had authorised AIM to increase their exposure to levels as high as 120%. This riskier strategy offered the possibility of greater returns – but also of greater losses. These clients understood this risk.

What AIM did, however, was something their clients didn’t seem to understand at all – when they eventually learnt the truth.

Many hats, no brain

The guys at AIM did a little extra trading that their clients didn’t know about. (Actually, it’s guy singular. The Chairman, President, CEO and Chief Investment Officer are one person. Many hats, no brain – as you’ll soon discover.)

AIM made some investments that increased their clients’ exposure level still further. They made these investments without their clients’ authority.

They were able to hide this from their clients because on or near the last day of the month they would sell whatever unauthorised investments they had made during that month. When their clients received their monthly statements, everything appeared to be in order.

A few days later, AIM would reinvest.

Fraudulent though it might have been, this clever strategy was working a treat up to April Fool’s Day, 2002. Between April 1 and July 22, the S&P 500 took a bit of a tumble. It fell from an index of 1146 to 819, a drop of 28.5%. Because of AIM’s extra-curricular activity, by the end of April they had under-performed the S&P 500 by an impressive 180%. Oops.

In an attempt to recoup some of the money they’d lost in April, AIM then embarked on an even riskier escapade by purchasing call and put options in many clients’ accounts. As the market continued to decline and the option contracts approached their June 21 expiry, the exposure in many of AIM’s client accounts continued to increase – from around 140% on June 3 to 385% on June 20. Uh oh.

But wait, there’s more.

Rather than quit and confess, AIM’s head man made one last bid to fix the mess he’d gotten into. He made what a punter would call a double or nothing bet.

On June 21 he bought numerous futures contracts. What he had bet was that the S&P 500 (which had dropped 3.2% in the first 2 weeks of June) would reverse course, causing the market value of his clients’ portfolios to rebound. Because exposure levels of some AIM clients were now as high as 500%, portfolios would regain their value with quite dramatic speed and everything would soon be hunky dory.

At least that was the plan. Of course, the reversal didn’t happen. And so this little story will go down in the annals of client loss as one of the most spectacular. Not subtle, not measured, not unexpected – but glorious in its scope.

The lessons for the rest of us

  1. Don’t do anything stupid
  2. Don’t do anything stupid and illegal
  3. Don’t do anything really stupid and illegal
  4. Don’t even think about it

Where can you learn the AIM technique?

Could the skills displayed by the one-man team at AIM be handed down to future generations? A subject called Advanced Investment Management is offered on the curriculum of several US colleges, so expect more spectacular fiscal shenanigans in the future.

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