Fearless Finance™

08 Jan, 2009

The Bernie Madoff Question

Posted by: earlhines In: Investing| Markets

Earl Hines

Investors want to know: “Who can I trust?”

As if investors didn’t have enough fear to deal with these days, the arrest of famed investor Bernie Madoff has Americans shaking their heads. Madoff, age 70, known as the investor with a golden touch managed for decades to pull off the biggest PONZI scheme in history — a whopping $50 billion! Granted, most of his investors were very wealthy people (including Hollywood actors Kevin Bacon and Kyra Sedgewick) who should rightly have been a bit more suspicious of his overly consistent performance. But many Jewish charities, private foundations, and smaller investors were also taken in by Madoff; and in too many cases, entire retirements have now been wiped out.

Investors are asking - how did this happen? Where were the government regulators? Indeed, the Securities and Exchange Commission fell down on the job — they had warnings from whistle blowers inside of Madoff’s organization as early as 1999. They even audited Madoff a half dozen times and supposedly found nothing. The post-mortem on this tragedy will go on for years, as Madoff’s prosecution progresses, and investors line up to try to recover as much as possible from his remaining holdings. But there are lots of people to blame for this mess - beyond greedy Mr. Madoff and beyond the SEC; specifically, investors themselves.

Here are some things that investors should always be on guard against to reduce the likelihood that they will be cheated in such investing schemes:

1. Don’t get too much of a good thing: You already know that the best risk management tool is diversification — spreading your investments across multiple assets, asset types, sectors, and geographies. Madoff’s hedge fund invested in securities and then used complicated options and futures strategies to enhance returns; investors may have wrongly viewed this as appropriate diversification. His returns became so good and predictable, that investors began to shift more and more of their assets to his fund. Just as you should not put all of your portfolio in a single stock or bond; don’t commit too much of your wealth to a specific fund manager. Most investors are familiar with mutual funds; they diversify assets on your behalf by buying underlying securities. You also want to diversify across fund managers. Too many of Madoff’s victims were simply holding too much Madoff.

2. Insist on a Separation of Powers: One reason Madoff was able to pull off his PONZI scam for so long was because his company served as both the Investment Manager for the fund and as Custodian for clients’ assets. Investors continued to get rosy statements from the Custodian showing their assets growing and growing, when in reality, the returns were fiction, and the assets they believed they owned were fiction. The role of the custodian (as opposed to the investment manager) is to keep assets safe for clients; and by having a separate custodian from the fund manager - it’s easier to keep track of any irregularities in account values, dividends and money movement. As an example, as an independent investment adviser, my clients never provide funds to me directly; I never take custody of assets. Instead they open accounts with a third party broker and custodian, like Charles Schwab, and then give me permission to manage the accounts on their behalf. They get performance reports from me, but also get trade confirmations and monthly account statements from the custodian as well. Transparency is what investors need and what they should demand. This is achieved partially by using advisers that do not also custody their assets.

3. Who is Checking the Books? Good fund managers with billions of dollars should be audited by the best and the brightest of accounting firms. Mutual Funds publish the name of who audits their books, and investors should find out who the auditor is and do a little research. According to news reports, Madoff’s auditor was a single CPA working alone in an office in lower Manhatten. Hard to imagine this poor fellow had the wherewithal to fully scrutinize a $50 Billion hedge fund.

I’m not blaming the victims of Madoff’s scam. But at the end of the day, investors have to use common sense when managing their assets. It’s your money; no one cares more about it than you do. Even though regulators were at best incompetent and at worst complicit in Mr. Madoff’s operation, many investors should have seen the red flags mentioned above. The old adage ”if it’s too good to be true…” applies here.

It is important to find and build trust in an investment adviser you can rely on, and then find out how they evaluate and select the fund managers they invest in. Don’t allow them or yourself to place too much of your portfolio with a single fund manager.

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Tags: Investing, Markets

Fearless Finance™

The Bernie Madoff Question

Investors want to know: “Who can I trust?”

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