Wed, December 31, 2008

Avoiding Madoff-esque Investment Scams

Wall Street Journal columnist Jason Zweig has pointed out that investors who should have known better were lulled into a false sense of security by the perceived exclusivity of investing with Madoff.  If they hadn’t been blinded by the desire to be involved with a prestigious adviser, his victims could have spotted some significant clues that would have protected them from losing their money in Madoff’s Ponzi scheme.

Legitimate Investment Advisers Are Registered
For most of the last 20 years, Bernie Madoff was registered as a broker-dealer, but not as an investment adviser.  Anyone who gives investment advice on a more than incidental basis must be registered with a state regulator as an investment adviser.  Any adviser who actually takes funds from people and is able to invest them directly must be registered with at least one state or (if managing more than $25 million in assets) with the SEC.  Madoff wasn’t registered as an SEC adviser until 2006, and for years he’d been managing billions.  For most of the time that individuals, institutions, and hedge funds were giving him money, he wasn’t properly registered at all.  I can’t figure out why this wasn’t a big red flag for the people who gave him money over all those years.

If you’re considering hiring an investment adviser, use the SEC’s web site to check his or her registration; the site includes state-registered advisers.  If an adviser isn’t properly registered, stay away!

Madoff was also regulated by the Financial Industry Regulatory Authority, (FINRA) a self-regulatory organization that used to be called the National Association of Securities Dealers (NASD).  The SEC site shows that he paid fines to the NASD twice over allegations of trading violations.  FINRA also maintains a registry for stock brokers; a look at Madoff’s file there would have revealed more violation claims. 

Though these kinds of accusations don’t prove that a broker is a crook, they should have at least prompted questions from more sophisticated investors.  An adviser who has been accused of wrongdoing should be able to offer a credible explanation.  The way that Madoff responded to such inquiries might have been instructive.

The “Gut” Check
Barron’s recently interviewed James Hedges, a hedge fund manager who considered investing with Madoff back in 1997 and decided not to hire Madoff.  His reason?  The meeting gave him bad vibes. 

Despite the fact that Hedges represented potentially billions in new money, Madoff refused to answer most of his questions.  Hedges wasn’t allowed to meet any of Madoff’s trading staff or know how much money Madoff was managing.  When Hedges asked for audited financial statements, Madoff refused to provide them.  After two hours, Hedges, said, “…what it told me was that it was a fraud, full-stop.... I have said over the years to many people: Do not touch Madoff with a barge pole.”

Other professional managers had questions about Madoff but went ahead and invested with him.  The Wall Street Journal quotes Swiss private bank Union Bancaire Privée, which now claims that it had reservations about Madoff but invested with him anyway because of his reputation.  The bank staked $700 million on Madoff’s reputation.

If you’re not satisfied with the answers that you get from an investment adviser, you shouldn’t hire him or her, period.  The adviser may not be a crook, as Madoff was, but if you can’t get answers that you consider satisfactory, that’s a bright red flag.  You shouldn’t be working with them; a good advisory relationship is built on mutual communication and trust. 

If you’d like to understand more about the different types of investment professionals, FINRA has a helpful resource on the differences between brokers, investment advisers, and other professionals.

Madoff Had No Independent Custodian
It’s standard practice for an investment adviser not to have direct administrative control over the funds managed.  Instead, there is normally an outside administrator and custodian providing statements and making the trades directed by the adviser.  In Madoff’s case, he was the adviser and the custodian; he was the only source of account statements.  This made it very easy for him to steal money.  There were hedge funds that chose not to invest with Madoff when they saw this arrangement, but there were others that invested with him anyway. 

The lesson here is that your adviser should have an independent entity in custodial control of your money.  Your investments should be going directly to that entity, not to the adviser.  It’s OK for the custodian to pay the adviser’s fees from your account, but the adviser should not also be the custodian.

Appropriate Auditing
The custodian of your funds should be properly audited on an annual basis.  If Madoff’s investor’s weren’t put off by the fact that their adviser and their custodian were the same person, they should have at least expected that an investment firm managing billions of dollars would use a major auditing firm.  Madoff Securities was using the well-known auditing firm of … Friehling & Horowitz, a three-employee firm with a lone accountant. This was another warning sign that his victims apparently missed.

Look For An Investment Strategy You Can Understand
Many of Madoff’s investors understood nothing about how he was generating profits for them; it was like magic to them.  Madoff’s explanation of his investment scheme made no sense to people who understood how such investment strategies worked.  If anyone had done the math, they would quickly have realized that the markets where Madoff was claiming to get his returns had trading volumes that were much too small to provide a 10% return to a multi-billion dollar investor.  All these clues were ignored.

If you hand money over to someone for investment, you should have a basic understanding of how the investment returns will be generated.  You don’t have to become an expert, but you should at least understand where the investment returns come from, and what could go wrong.  This leads me to the final warning sign –

Guaranteed Returns are Bogus
According to Madoff’s clients, he paid out profits like clockwork, year in and year out.  I’ll admit that this was not an absolute giveaway, because it can be hard to distinguish skill from luck where investing is concerned.  But the professionals who were investing with Madoff should have recognized that the investment technique he claimed to use could not have generated positive returns month by month over such a long period.

The lesson here is twofold:  If an adviser’s performance sounds too good to be true, at least be suspicious.  Do your homework, or hire an independent evaluator to do it for you.  Second, if anyone ever offers you an investment and implies that profits are “guaranteed,” run away from that person with your fingers in your ears.  There are a few investments backed by government guarantees, but beyond those, there are no guaranteed investments.  There are always risks somewhere.  Any adviser who doesn’t make that clear to you should be avoided like the plague; he either doesn’t know what he’s doing or isn’t telling you the whole truth.

Learn From Doctor Doom: Don’t Put All Your Eggs in One Basket
The reports of the people taken in by Madoff continue to impress me.  Today the WSJ reported that Henry Kaufman lost several million dollars in an account with Madoff.  Kaufman, who used to be the chief economist for the investment bank Salomon Brothers, is such a Wall Street legend that he even has a nickname: Dr. Doom.  Kaufman should have known better, but he was still smarter than the people who gave most or all of their money to Madoff.  Kaufman reports that the multi-million dollar loss was “no more than a couple percent of [his] entire net worth.”

Kaufman invested on the basis of Madoff’s reputation, but wisely, he only risked a small part of his capital without doing further due diligence.  As my accountant likes to say: he could have done worse.