Lessons from the Madoff scandal

By now, investors are only too familiar with Bernie Madoff, a once-storied hedge fund manager, who, it turns out, was running nothing more than a massive ponzi scheme. The size of losses tied to the scandal is so enormous that one hopes it will eventually lead to regulations that aim to minimize the chances of another Madoff-like fraud. But by applying a little common sense to their own situations, individual investors can also take steps to reduce their vulnerability to investment scams. Here are a few very basic guidelines that should help keep you on the straight-and-narrow.

If it sounds too good to be true, it is.
Investors flocked to Madoff not because he generated ostentatious returns, but because he had a reputation for delivering above-average returns year in and year out. Each year, supposedly without fail, he produced returns in the low double-digits. Perhaps that was the reason he got away with it for so long. Blow-out returns would have raised suspicions, but modest market-beating returns did not. In hindsight, though, they should have. Even the most talented managers hit the occasional rough patch (as 2008 has painfully demonstrated), yet Madoff purportedly never had an off year. That strains credulity. Any investment that promises either outsized or consistent above average returns should be viewed with extreme skepticism.

Diversify, diversify, diversify.
Apparently, even the most obvious truisms can’t be repeated often enough. The investors who were hurt the most by Madoff were those who entrusted all of their assets to him. Perhaps it was Madoff’s return claims that lulled them into a false sense of security. Who needs diversification when you can get a steady 10-12% return every year without fail? But that kind of return consistency is nothing more than a fairy tale, as any experienced investor can tell you. In reality, some investments and asset classes will perform well while others will struggle. One year’s winning investment is just as likely to be next year’s loser. That’s why it’s important to hold a mix of asset classes in your portfolio. The fact that a few hedge fund-of-fund managers didn’t adhere to this most basic of investment principles is shocking, which brings us to the next lesson…

Be aware of potential conflicts of interest.
Instead of allocating their investors’ assets across several different hedge funds, a few fund-of-funds managers let it all ride with Madoff. Why would an investment professional be so reckless with his clients’ money? And why would other professionals fail to conduct adequate due diligence and oversight of the funds they held and/or recommended? The answer partly lies in a misguided incentive system that is rife with conflicts of interest.

Some of these fund-of-funds managers’ firms were earning several millions of dollars in fee income from their Madoff investments. Others were likely receiving kickbacks from Madoff himself. These managers had every incentive to maintain the status quo. They didn’t want to jeopardize their own paychecks by asking hard questions about their prize holding.

While not quite as extreme, similar conflicts of interest exist in the retail investing world. For example, some advisers may increase their income by directing client assets to funds with higher loads or to funds that offer larger trail commissions. While the great majority of advisers do the right thing for their clients, an unscrupulous few may favor some funds over others, regardless of their clients’ best interests’ interests, simply to juice their own incomes. That’s why it’s important to understand how your adviser is compensated for his or her services. If your advisor balks at providing this information or tries to gloss over it, be suspicious. One of the red flags in the Madoff scandal was his reluctance to provide shareholders even the most basic information, such as total assets under management or financial statements audited by a reputable qualified firm.

Some advisors, with the encouragement of the FSA, are migrating to a fee-only system that frees them from such conflicts of interest. Fee-only advisers aren’t compensated via loads, commissions, or kickbacks. Instead, clients generally pay an upfront fee or a certain percentage of assets (generally around 1%) for the adviser’s services. That way the fee arrangement is totally transparent, unlike the system that predominates now.

Clear conflicts of interest also exist between fund shareholders and fund companies. Fund companies must serve two masters: the shareholders in the firm, and the shareholders of the firm's funds. For example, investment management firms have little incentive to share economies of scale with shareholders by lowering fees, as (at least in the short term) this would cut the profits for the firm's shareholders. Nor do they have incentive to close or significantly reduce inflows into funds that are growing too large--although this would be good for the funds' shareholders, it would again hurt the firm's short-term growth prospects. Fund firms also often heavily market narrowly focussed "hot-dot" funds in an effort to gather assets--a strategy that can burn fund investors who buy them wihtotu understanding their risks. Yet, some fund companies choose to do the right thing because they believe that they will reap long-term rewards if they take good care of their shareholders. We couldn’t agree more. One of the best ways to avoid investment scams is to invest with fund firms who have a long record of putting fund shareholders first.