Lessons from the Bernard L. Madoff Fiasco

“Many aspects of the Madoff affair are depressingly familiar: the lure of high returns with little risk, glowing testimonials from early investors, the sense of membership in a special club for those fortunate enough to be ‘in the know,’ the trust in the promoter due to religious or social affiliation, the vague documentation of investment strategy, the skimpy accounting, and the speed of the ultimate collapse.” – Weston J. Wellington.

There has been much written about Bernard L. Madoff, who is accused of running the largest financial fraud scheme in history, and all of it sordid and sad. The sorry tale raises serious questions and concerns about how well (or how poorly) the Securities and Exchange Commission, the so-called watchdog of the U.S. securities sector, did its job. It also makes you wonder how it was that so many “sophisticated” investors could have been so thoroughly fooled.

A recent New York Times column, Be Smart, but Don’t Think That You’re Special  by Ron Lieber and Tara Siegel Bernard, summarizes the debacle as follows: “When wealthy investors are willing to hand over a sizable sum to a single money manager they heard about at the country club, certain first principles of investing bear repeating.”

Here are some useful quotes from the article:

… scores of people made outsize bets on his prowess without taking the time to fully understand what they were investing in.

All investors, but especially those with a high net worth, need to maintain a healthy sense of humility about their level of ignorance. Alternative investments, whether they are hedge funds or venture capital or private equity, can be complicated. They contain unpredictable levels of risk. But all too often, people are willing to overlook those risks because, well, everyone else is doing it. Or they simply place too much trust in too few hands.

Humility

Investing, in general, requires humility. Few people have enough of it. It is the reason so few people put most of their money in index funds, which track various asset classes rather than trying to pick the winners in each.

One problem with hedge funds is that they appeal to all the wrong instincts. They are for the privileged. Investors need to have a minimum net worth to qualify. In the case of the money managed by Mr. Madoff, many people seemed to have gotten in on it by belonging to the right country club.

“He was dealing with extremely wealthy individuals,” said Harold Evensky, president of Evensky & Katz, a financial planning firm in Coral Gables, Fla. “All too often, they make relatively easy marks because the pitch is, ‘You’re special, you can get something that other people can’t get.’ ”

But you are probably not special. Bill Gates is special, and he is the beneficiary of the best investment opportunities from the smartest people in the business. The Ford Foundation is special. The people who run Harvard and Stanford and Yale’s endowments are special.

You, however, are probably hearing about the second- or third- or fourth-tier ideas in the world of alternative investments. That does not mean the managers pitching them cannot make them work. But be honest with yourself: if you are in on them, how special could they really be, given the enormous demand for truly unique investment opportunities?

Smarts

You may be rich and you may be smart. But smart about this sort of investing? Not so much.

There is no shame in not understanding Mr. Madoff’s split strike conversion strategy. Admit your ignorance, question your investment adviser’s certainty and seek a plain English explanation of the opportunity that is in front of you.

Secrets

One hard part about investing in hedge funds is that some of the most successful ones will not say much about how they work. If they disclose too much about their tactics, others will copy them and their investors will be hurt. (So will the managers’ take-home pay.)

While Mr. Madoff’s supposed returns were fully available to all, investment advisers were less successful in understanding how he did what he did. “I knew that their returns were always good, but I knew that nobody could explain how they made their money,” said Mr. Weinberg. “In our attempts to look under the hood, it was impossible to ascertain what they were doing.”

Conclusion

Let’s review some of the “red flags.”

Madoff had complete control of his clients’ investment funds. This is absolutely contrary to the recommended procedure of having your funds held separately, in custody, at a broker-dealer firm which is regulated by the Financial Industry Regulatory Authority and backed by the Securities Investor Protection Corporation. As an investor, you should be receiving copies of your statements directly from the (independent) custodian, not from your investment manager.

You need to understand the investment strategy that your investment manager is recommending. Avoid the “black box” approach to investing; look for investments that are clear and transparent.

Question any investment record that looks too steady over the long term. All investments have some risk, no investment is a “sure thing.” (Bear in mind that other investment managers could not duplicate Madoff’s investment performance, using similar strategies, so what “magic” did he possess that others did not?)

As the saying goes, “If it seems too good to be true, it probably is.”