You Can't Cheat an Honest Man - James Walsh [39]
Donahue dealt with hesitant investors in a disarming way. Rather than working hard to persuade, he simply told people to take their money elsewhere. “he used to say, ‘Look, I could just as well take your money and throw it in the ocean. If you are not comfortable with the way I do things, don’t participate,’” said one Denver-area financial advisor.
What Donahue did do was guarantee investors a 25 percent annual return on their investments. He said his options investment program always produced returns of at least 19.7 percent. These numbers were compelling enough to make many investors forget their skepticism. When a person invested in Hedged Investments, Donahue would sell him or her shares in one of three limited partnerships. Donahue’s strategy was to combine buying or short-selling a stock with investing in call (sell) or put (buy) options in that stock. Whether the stock went up or down didn’t matter; Donauhue’s goal was to exploit inconsistencies in the small niches of the financial markets. (Theoretically, the price of a stock corresponds consistently to the price of its options; but markets sometimes make mistakes. When they did, Hedged Investments would make money.)
Buying stocks and selling call options is considered a conservative investment strategy. But Donahue sometimes varied his positions so that he was investing more heavily in options—a far more speculative move. But, by using complex statistical models, Donahue seemed to make it work profitably. “There was always the possibility a stock would jump outside the range and cause a loss,” says Gregory McNichol, a money manager who helped Donahue establish his system. “But if he had 20 positions, it’s hard to imagine any one being bad enough to wipe out profits on the other 19. He used to preach the discipline of this thing.”
But he practiced something far looser. Donahue failed to maintain separate accounting records for the Debtor Partnerships and commingled investors’ funds into a single checking account. In other words, he treated the investors as if they were direct participants in a single investment pool instead of investors in discreet limited partnerships.
Donahue made money his first three years of operation, from 1978 to 1980, when he managed less than $2 million in assets for a small group of investors. But for the rest of the decade, he lost money routinely. After a few years, the program was insolvent— in that its cumulative losses exceeded its cumulative gains. The true source of funds paid to the investors as earnings were the funds obtained from the sale of partnership interests to new investors.
Beginning in 1981, Donahue lost $2.1 million, then $1.7 million the following year, $2.6 million in 1983, slightly under $1 million in 1984 and slightly over that in 1985. In 1987, the year the stock market crashed, Hedged Investments lost $6.5 million. Far from admitting his losses, Donahue told clients and potential investors that Hedged Investments not only survived the Crash, but had achieved a 26 percent annual gain.
His losses nearly quintupled in 1988, when he dumped $29 million into the market. There was some relief the next year when he made $5.7 million, but it was short-lived. And then, in 1990, he gambled on a heavy investment in United Airlines for his financial salvation. And lost.
In the course of a few weeks, Donahue lost $90 million trading United Airlines options. There had been talk of a takeover at United; he believed it would come. As Wall Street concluded there’d be no takeover, the value of United options dropped—and Donahue kept buying. “There’s an old saying in investment circles: The trend is your friend. Don’t fight the trend,” says one West Coast money manager who knew Donahue. “He knew this. He just lost his mind.”
Normally, Donahue pooled all of his investors’ money in to a handful of accounts. But, late in his scheme, he made one