I tell those who ask that there are two types of successful investors: the skeptical optimist or the optimistic skeptic. Either of these might have identified a number of reasons to stay as far away from Bernie Madoff as possible.
Avoiding fraud is not rocket science but then too, the regulatory authorities do not make it easy. In the Madoff case an objective observer might wonder how it could happen.
How were so many intelligent people, including professional money managers, duped for so many years? A quick and easy answer is that the client-victims seemed to have placed perception ahead of due diligence. An unkind critic might reverse the words in that phrase – “If you’re so smart why aren’t you rich?” The investors may have relied on reputation, image, and the word of other investors as the basis for their trust. It is the latter, client testimonials, that are the lifeblood of any Ponzi scheme. The client who unknowingly receives the principal investment of newer clients as his “investment return” can become the unwitting source of additional victims for the perpetrator.
A deeper examination reveals a higher level of complexity. Bernard L. Madoff Investment Securities LLC is an investment advisor registered with the Securities Exchange Commission. This implies investor protection in the form of regulation and oversight. If an advisor retains custody of client assets then he must have independent audits performed in addition to the unannounced audits conducted by the Commission. If the firm does not retain custody (we are in this group), then the client has the statements of the third party custodian to match against the advisor statement. This check and balance system is virtually fraud-proof. In the Madoff case, the independent accounting firm was an obscure, two-person outfit. That relationship alone raises the first red flag.
However, a review of the advisory firm’s ADV, available to the public at the SEC website, should have raised additional questions. Item 5 of the ADV application provides information about the advisory business. For example, for the answer to the question about how many employees perform investment advisory functions including research the box “1 to 5″ was checked. Question B (3) asks how many firms or other persons solicit clients on your behalf. The answer checked here is “zero”. For question C the box 11 to 25 is checked for number of clients served and that is confirmed in question F which lists 23 discretionary accounts totaling $17 billion in assets.
If you were a prospective investor from Palm Beach being solicited by an outside firm and you knew of at least thirty other individuals locally who invested with Madoff, you would need some clarification to those ADV answers. A look back at question D which asks about types of clients provides a clue. Here “51-75%” was select for item (6) – other pooled investment vehicles (e.g. hedge funds). It is clear now that your investment will be under the umbrella of a Madoff hedge fund and that S.E.C. oversight and regulation does not apply. Before making a decision to invest you could examine the characteristics of The KL Group, a West Palm Beach hedge fund that went under in recent years.
Despite the wide difference in scope, you would find the following in common:
The principals led a first class lifestyle, had a history of success, and were perceived as experts. The annual returns were well above normal, almost “too good to be true”. Their offices were expensive and well appointed. Their strategies were secretive and too complicated to explain. They were selective as to client acceptance. Their clients relied solely on company prepared reports.
Dorothy eventually did return from the land of OZ but not before finding out that the wizard was just a befuddled old man behind a curtain. Image and reputation are easy to produce; long term, extraordinary results are not. If not given the opportunity to pull all the curtains aside, your internal skeptic should overrule the resident optimist.