Basically, the problem is investors look for funds that deliver consistent returns. Madoff did that, to nearly-statistically impossible degree. Every year, his funds gave returns of 10-11%. Every month, gains were between 0 and 2 percent. The Big Money writes:
A fund that returns the exact same amount every month is perfectly serially correlated. Madoff’s returns were strikingly consistent month after month, year in and year out. That kind of performance—a nice, smooth line going up no matter what the market does—is a really good sign that you should look more closely.
What Lo shows from the pattern of historical returns in hedge-fund databases is that when funds’ returns grow too consistent, it is a sign that the investments are either very hard to value accurately and the returns are just guesses, or, worse, that they’ve been manipulated in a way that smoothes them artificially. What Lo creates is a mathematical model for judging what “looks too good to be true.”
A high degree of “serial correlation” doesn’t prove that a fund is being artificially massaged, but it sure is a warning sign.
Bonus fun fact: With at least $50 billion gone, Madoff’s scheme could be the largest investor swindle in history.