Madoff

A person seeking a money manager faces two kinds of risks: The risk of getting a bad manager plus the risks of the investment products themselves. A DIY person faces only the latter risk.

Moreover, those risks are not independent. If you happen to get a bad manager, your investrment products often turn out to be riskier than you would like. If you get a good manager, you can still lose money if the market crashes.

In light of the Madoff story and all the company bankrupties nowadays, I would question the extent to which the expertise of a manager is superior to that of a conscientious DIY person.

I don't have the details but it seems that Madoff invested for companies. I assume companies sending their client's money to him to invest. Personally I would never invest with someone using his method, i.e. trading stocks to make small gains. I am a long term value investor. I have talked to several money managers who would invest from one of my accounts, so I would at all times know what is being bought and sold. I would never just give my money to someone to invest.

Here's my other question about this "Madoff affair".

Supposedly the "investors" were making 15% per annum. Also, according to news, Madoff told them that he was in cash at end of every quarter. This means that the reported profits were "short term trading gains". Therefore, Madoff had to report them to the clients for their tax reporting.

Since these clients were rich, they probably were routinely audited. If so, has IRS tried to match those reported numbers with Madoff's tax filings?

I really do not understand how this may have gone undetected by the IRS.

My own thinking on this is that it is next to impossible to construct an incentive system that would properly compensate such a manager. This is my main reason for not seeking any such management or advice. (that said, I am stuck with my mutual find selection in my

401k and my wife's).

I am not a very great investor and have too little time to read to invest in many different issues. I have to work, have 2 kids and one hobby. But, a lot of conscientious thinking permitted me to avoid both the crash of 2000 as well as the crash of 2008. (after the crash I am now fully invested). I cannot imagine a "money manager" who would have enough guts to tell me to avoid investing in stocks, prior to these crashes. I also have a hard time imagining a "manager" who would tell me to invest myself fully. Of course, it is not a given that this latest decision is a good one.

Personally, I am beginning to think that in the long run, not losing money may be more important than trying to get high returns.

i

Individual investors would only report capital gains from a mutual fund investment. They don't provide details as to buys and sells.

The IRS is responsible for collecting taxes and investigating tax fraud. If the amounts reported on Form 1040 and schedules match the amounts reported on the Form 1099s the IRS has nothing to investigate. Why would the IRS even consider investigating people reporting millions of dollar of income from

1099s and paying millions of dollars in taxes on the reported income?

Common sense tells me that an investor cannot beat the market consistently and in such spectacular fashion, and that there is something amiss when the contrary appears to be happening.

So while I think that Madoff deserves what's coming, the investors made terrible choices (at the minimum they could have have asked for a second opinion) and they are not without blame. Further, if I were a beneficiary of some of the foundations whose leaders got them in this fix, I would hold them accountable.

-HW "Skip" Weldon Columbia, SC

The facts that nobody was privy to his strategy - including his own sons - plus the claim that he went to all cash by the end of every quarter - were both quite suspicious.

Most of them were put into this investment by advisors and/or through funds-of-funds, some of whom (said "advisors" as well as the managers of those funds-of-funds) got rather rich themselves in the process.

Madoff had a great reputation. And he did, in fact, pay investors a lot of money over time (all of it, apparently, their own money). Lots of folks apparently let that get in the way of a deeper and more skeptical analysis.

Moreover, a lot of folks seem to have concentrated a lot of their money into this one fund. I don't have much of a problem with concentrating in one (or a couple) of funds if those funds are managed transparently and with adequate diversification and obvious competence. But to put a large swath of one's money into a totally opaque "system" with minimal oversight and without diversification is amazing. There were investors who were completely wiped out - I really have to wonder what they were thinking. I don't know of any competent advisor who would so highly concentrate his clients investments into such a vehicle.

I'm not sure there's anything they can do in that regard, though there may be a case to be made regarding dangerously bad advice in the cases of foundations and other orgs who'd hired advisors to find this investment, particularly, as I said above, if said advisor put them entirely (or the bulk of their investment) into Madoff's black box.

I havent seen all the details yet, but I wonder if this yet another case of improper diversification. The conventional wisdom is never to put more that 15% in one investment (assuming you have a large enough pot that the fees of managing six+ investments doesn't cut into it.) My first thought was "Enron all over again". The Enron 401K had diverse options, but most employees only bought Enron stock because it doubled every other year. Likewise I wonder if people got too concentrated in Madoff because it had good returns for a long time. When I hear people saying they lost 100%, it rings that bell in my head.

Just read an article on the list of investment firms that are NOT on the Madoff list. They interviewed one of the principles of one of those firms and the guy says essentially if you go through all the dur diligence as his firm did you wouldn't invest with Madoff either. Top of the list, Madoff could not explain his investment philosophy.

I've read a lot of bad-egg investment adviser cases and as with Madoff, many of them are outright theft/fraud, and there seems to be one scenario that comes up more often than you'd expect: a lack of third-party account statements from an independent custodian. Instead the clients are getting only some laser-printed thing from the advisory firm itself, which makes it easy for them to say anything they want about account values, gains/losses, etc.

In a sense that makes it easier to steal from a $5 million client than a $5,000 client. The $5M client accepts documentation that the $5k one just wouldn't put up with! And to be fair, just by nature, certain investments aren't going to have any third-party statements...e.g. a hedge fund is organized as a partnership and issues only periodic reports (which may be unaudited) and K-1s for tax purposes. This is very different from a managed account of investments held through one of the big custodians.

It will be interesting to see how Madoff actually did it, without it being discovered by SEC auditors or consultants paid a lot of money to do "due diligence". It seems likely that many more people were involved in the scheme, if it truly is as big as he said it might be ($50B). I have no idea how you'd mask that much fraud, for so long, in so many client accounts.

-Tad

Ted, I think that it is spot on.

What a great answer.

Not contradicting what you said, but adding, I think that Madoff may have started out with good intentions, lost a lot of money at some point, and could not bring himself to admit it, so he had to continue with his fund as a Ponzi scheme.

You haven't read the news stories about Madoff closely enough.

Madoff did not "beat the market consistently and in such spectacular fashion". He falsely claimed to be producing about 11% a year. From 1995 to

1999 the S&P 500 total return by year was 37.58%, 22.96%, 33.36%, 28.58% and 21.04%. Madoff severely underperformed the S&P 500 (let alone the Nasdaq Composite) from 1995 to 1999 for 5 years in a row, yet he didn't seem to have lost many clients.

Madoff's clients liked the slow, steady returns and apparent low risk (no losing quarters). If Madoff's clients were interested in spectacular returns they would have taken back their investments in the 1990s and gone elsewhere. Madoff's version of the Ponzi scheme was diabolical and fiendishly clever in using low, but steady and above average returns (compared to money market funds or corporate bonds) to hang on to clients money and attract new money. If Madoff had been claiming 20% or 30% annual returns he would have been caught many years ago.

Madoff's investors were too gullible and not willing to ask any hard questions. They were more afraid of not being able to invest with Madoff than with performing due diligence. The lesson of the Madoff fraud is that if you find what appears to be the ideal invesment and you are very comfortable with it, then is most certainly not legitimate. For every asset class, below average risk with above average returns does not exist.

Another question is that hedge funds (prospectus not required) are limited to 99 or 499 participants. Sounds like this guy had more than that investors. How'd he get around that?

Easy. He wasn't running a hedge fund. He was an SEC-regulated registered investment advisor.

-- Rich Carreiro snipped-for-privacy@rlcarr.com

I think that I am beginning to understand it a little better.

The issue is that this Madoff was a very bright guy with a huge experience on Wall Street. He was not a random street thug with a bright idea.

So, instead of opening his own hedge fund, instead he let other people organize hedge funds, and then took their money to run his Ponzi scam.

In other words, investors were not investing directly into Madoff, but instead they were investing into various "feeder funds" that Madoff's accomplices would recommend to them.

That greatly cuts down on the possibilities of uncovering his fraud, as Madoff would not send statements to investors, but only to hedge funds.

It's even worse! He didn't even register until 2006 according to the article in today's WSJ, but that wasn't such a big deal in the eyes of the SEC:

Madoff Misled SEC in '06, Got Off, WSJ 12/18/08 "On Jan. 4, 2006, the SEC's enforcement staff in New York opened an investigation...The SEC report also said Mr. Madoff had violated rules requiring investment advisers to register with the SEC, which makes them subject to inspections and examinations. Investment advisers must register if they have more than 15 clients.

The staff recommended closing the investigation because Mr. Madoff agreed to register his investment-advisory business and Fairfield agreed to disclose information about Mr. Madoff to investors. The SEC report said the staff closed the case 'because those violations were not so serious as to warrant an enforcement action.'"

What a horrible precedent. Running an unregistered advisory business for years, with billions under management, "is not so serious as to warrant an enforcement action."

Then what is...?

-Tad

PS I suppose in the interest of disclosure I should mention that I am a state-registered investment adviser...who like most advisers, assumes that if even one tiny piece of paperwork is so much as wrinkled when we're audited that we'll get a ding letter from the regulators.

It is interesting to speculate about what Madoff himself hoped to accomplish by his scheme. One possibility is that he succumbed to the same motives as the greedy investors who took his advice. Perhaps he believed his Ponzi schemes could go on working forever, just as the investors in those schemes believed their high income would continue forever. Greed can take hold of people who should know better.

Another possibility is that he knew full well that the scheme would eventually come to an end and that he would be arrested, but that by that time he would have accumlulated enough wealth to offset the risks of a trial and prison. Perhaps he stashed away considerable sums of money in havens outside the USA. Perhaps he is counting on the advantages possessed by the rich in the criminal justice system and to the relatively light prison sentences given in cases of financial fraud. Perhaps he is looking forward to the day when he will be released and be able to leave the country and enjoy his riches (five year sentence, out in two?). It will be interesting to see just what penalties are handed down by the courts.

The only other possibility that I can imagine is that he was mentally ill and prone to self-defeating, suicidal behavior. Or that his illness took the form of those people who try to assassinate political leaders because of a pathological desire to get attention and publicity.

My own speculation is that he started off with earnest intentions, kept making money for a while, then finally lost a lot of money. At that point he could not admit his failure and instead continued his business as a Ponzi scheme.