What We Can Learn from Madoff

“Bernard Madoff was able to pull off what is allegedly the largest investor fraud in history because people trusted him. But why did people believe his lies when there were so many reasons not to?” – Blaine F. Aikin.

For a full month, I have avoided writing anything more about Bernard Madoff; not because there was nothing new to say, but because it seemed that there was so much readily available about the tragedy.

However, an article in the January 18, 2009 edition of Investment News is worth highlighting. What We Can Learn from Madoff  by Blaine F. Aikin discusses how a proper fiduciary investigation should have and did raise many red flags.

Here is a summary:

Good fiduciaries are necessarily skeptical, so they sought verification of key information before they would invest. Their due diligence paid off; they uncovered troubling information in six areas of essential inquiry for fiduciaries.

First, Mr. Madoff didn’t use an independent custodian.

Second, his financial auditing was provided by a tiny, obscure accounting firm.

Third, Mr. Madoff produced his own performance reports and wouldn’t allow independent performance audits.

Fourth, the extraordinary investment success claimed for the fund didn’t jibe with reasonable investment benchmarks, and the results couldn’t be substantiated when subjected to fundamental testing of the trading strategy.

Fifth, the business structure of the fund made little economic sense. Moreover, it seemed designed to avoid regulatory oversight and to frustrate due-diligence efforts by prospects and clients. Rather than organize as a hedge fund and charge a lucrative performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds.

Finally, he showed little appreciation for, and no processes to apply, fiduciary standards of care. … He rejected potential investors who asked penetrating questions, reacting to such inquiries as an affront to someone so accomplished in creating wealth.

Conclusion

There were many hedge funds which invested their clients’ money with Bernard Madoff. The hedge fund managers collected sizable fees for being conduits or “feeders.” Amazingly enough, they claim that they did their homework and investigated Madoff thoroughly. One firm in particular was quoted in the New York Times on December 14th defending their actions.

The Fairfield Greenwich Group “performed comprehensive and conscientious due diligence and risk monitoring,” Marc Kasowitz, a lawyer for Fairfield, said in a statement. “FGG, like so many other Madoff clients, was a victim of a highly sophisticated massive fraud that escaped the detection of top institutional and private investors, industry organizations, auditors, examiners and regulatory authorities.”

Now, Fairfield is seeking to recover what it can from Mr. Madoff.

The fraud was long lasting, and the red flags should have been apparent. Some investment managers completely missed the warning signs. But not all. According to Blaine Aikin, “a number of dedicated fiduciaries, including several large financial institutions, investment advisers, retirement plan sponsors and endowment administrators, found Mr. Madoff’s magical ability to generate consistently stellar returns to be too good to be true.”

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.”