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 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not peer-reviewed so there were no independent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
- 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
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
Extracted from Madoff: A Riot of Red Flags,
prepared by finance professors Greg Gregorius and
Francois-Serge Lhabitant for EDHEC
Risk & Asset Management Research.