Issue: March/May 09


The greedy and the gullible

Looking only at returns and being blind to how they’re made has enabled the world’s biggest Ponzi scheme. Trustees of retirement funds, take note.

Bernard Madoff, the Wall Street darling of wealthy individual and top-flight institutional investors across the world, has taken them for a multi-billion dollar ride. Their pockets denuded, they deserve embarrassment and pain for their own lapses in not having detected that Madoff was a fraud.

Even if they hadn’t discovered that his method was to produce consistently above-average returns for earlier investors from inflows by the later, there were more than sufficient warning bells of behaviour seriously amiss.

The tragedy, as always, is in the innocents who suffer: the charities Madoff had no qualms in grabbing; the friends whom he made to feel part of a select circle; the non-financiers who trusted in their advisers.

This is not to view the debris with the benefit of hindsight. Rather, it is to spell out what should have stared investors and regulators in the face. While SA asset managers might breathe with relief that exchange controls constrained their possible exposure to this supreme confidence trickster, they cannot ignore the perils from an absence of due diligence that could one day befall them as they did some of the most prominent names in international finance:

Madoff... with the money
Madoff... with the money
  • Madoff didn’t claim to be a manager of hedge funds. He relied on feeder funds, marketed by intermediaries, which had to open brokerage accounts and delegate to him full trading authority for their portfolios. Pleased to receive annual returns consistently at 10%-20%, they were content for his miraculous investment strategy to be kept dark;
  • A hedge fund typically uses a network of service providers. They’d include an investment manager, a broker or several brokers to execute trades, an administrator to track asset values, and a prime broker to keep custody of the positions. Segregation of these functions helps reduce the risk of fraud. With Madoff, all these functions were performed internally and there was no third-party oversight. He also produced all documents that purportedly showed the underlying investments;
  • Madoff was audited by a small, obscure accounting firm which had declared in writing to the Institute of Certified Public Accountants that it conducted no audits. Accordingly, the firm was not peer-reviewed so there were no independent checks of its controls. Feeder funds were audited by reputable firms, giving their investors comfort, but apparently these firms relied in turn on Madoff ’s auditor;
  • Madoff took only commissions on trades. He left the management and performance fees, amounting to hundreds of millions of dollars each year, to distributors. Nobody seemed to question why he chose to forgo these fees when investors were queuing to give him money;
  • Several feeder funds never mentioned Madoff. Final investors were not necessarily aware they were investing with him. Such secrecy, compounded by Madoff who was reluctant to disclose assets under his management, was curiously modest in the face of his uniquely successful investment strategy;
  • Key executive positions at Madoff were held by his family members. This undermined the independence from one another of such functions as senior management, administration, trading, market making and compliance;
  • In his regulatory filing, Madoff indicated he had a staff of up to five employees to perform investment advisory functions including research. At the same time he disclosed $17bn under management. Nobody seemed to pick up on the contradiction of so few people handling so much money;
  • Madoff never provided customers with timely, electronic access to their accounts. Feeder funds received only paper tickets through the post. This enabled him to manufacture trade tickets confirming the investment performance he wanted to show.

Where, then, was the regulator? In the US, investment managers who exercise discretion over $100m or more of assets must use a particular publicly available form for quarterly disclosures to the Securities & Exchange Commission. While Madoff had positions of over $17bn, his forms usually showed only positions in small-equity stocks. His explanation was that, at the end of each quarter, he moved mostly into cash to avoid making public the information about securities he was trading on a discretionary basis.

Had he been doing as he said, at the end of each quarter there would have been massive movements on the money markets. Nobody thought to ask why there weren’t.

Extracted from Madoff: A Riot of Red Flags, prepared by finance professors Greg Gregorius and Francois-Serge Lhabitant for EDHEC Risk & Asset Management Research.