Tuesday, December 16, 2008

Bernie Madoff & The "Sophisticated" Investor

This week's panic over the Bernie Madoff investment fraud points out how much of a cottage industry investment management continues to be. And probably will remain.

As a veteran of the business for over a decade, I can attest to the thoroughness with which some potential investors conduct due diligence.

My initial hedge fund partners required me to replicate my strategy's results using their performance data and software system. It was a very clever approach, since I was forced to cede control over the total return data with which, had I been marketing a fraudulent system, I might have fooled them. As it was, their insistence on my reproduction of the strategy on their system resulted in the elimination of some minor errors and some improvements elsewhere in the approach.

In another case, a potential investor required exact times, dates and tickers of equities which I had bought for my personal account, in order to reconstruct my returns, to the penny.

Never did I have anyone simply accept my return series as prima facie evidence of the strategy's effectiveness. At the least, names of the equities held in each period were required, along with a monthly return series.

So it's incredible to learn that Madoff posited a steady, unchanging 1% per month return, and attracted virtually no in-depth investigation from the bulk of his investors.

However, it's not all that surprising to me that Madoff was able to run his scam for so many years.

The keys, it seems to me, were two-fold.

First, by alleging to manage individual accounts, rather than a fund, he avoided any serious SEC inspection and regulation. The allowable minima for a number of accounts managed individually prevents anyone from every really knowing whether you are in violation, or not.

Madoff's insistence on keeping the activity quiet, ostensibly because of his brokerage operation, resulted in nobody ever asking to see regulatory filings on his activities. Or, if they did, the second key to his success came into play.

By beginning with an attitude of, lets be frank, arrogance, Madoff challenged people's self-confidence. Madoff used what my business partner calls the 'club deal' approach. That is, you are favored by a personal contact with the opportunity to 'get in on' a sweet deal. But you have to just sign up and hand over your money- you can't actually delve into details.

Rather, you are supposed to be so flattered with the chance to participate. And, in fact, we have already heard stories of lucky escapes by wealthy but sceptical investors who did ask too many questions, those questions which were either ignored, or the investors were then declined the opportunity to participate.

The list of those who were bamboozled by Madoff grows daily, and even affected investor confidence yesterday, helping the S&P to drop by 1.3%.

As if the last 18 months of financial markets behavior haven't been sufficient to strike fear into equity investors, the Madoff saga seems to be a fitting bookend on which to close out 2008. If not for Madoff being affected by redemptions, like so many other investment managers, his scheme may have run for years into the future.

Apparently some $50B is gone in a classic Ponzi scheme. Some investors with realized gains may even be approached to return the gains. There's no way, at present, to know if any of the reputed performance Madoff ever had was real, or if it was a scam from the very beginning.

I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements.

It's still early innings in the case, so we don't know the extent of complicity of various other people who worked in or with Madoff's investment firm.

But the scope of the fraud is staggering. As is the caliber of the people he bilked.

And, sadly, the one thing we know is that it's not the last time this will occur. Jason Zwieg's article in this weekend's Wall Street Journal pointed out how feelings of inadequacy to even ask questions, on the part of most of Madoff's clients, greatly assisted the ease with which his scheme operated. As well as Madoff's judicious use of initial clients to whom others would look up, and, feeling, again, less confident, simply invest without asking questions.

Human behavior seems to have some enduring components through time, and these certainly qualify. That's why Madoff is just the latest in this saga, not, unfortunately, the final chapter.

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