Issue 48 - December 15, 2008

An Old Fashioned Swindle

Bernard Madoff was arrested late last week, accused of masterminding the single largest fraud in US history (bigger than Enron and bigger than WorldCom). Mr. Madoff apparently employed a strategy known as a Ponzi scheme, named after Charles Ponzi, an early 20th century figure, where one simply uses the principal of one investor to pay the return of another. As long as new assets are coming in the door, it would be theoretically possible to pursue such a plan for a long time. The trouble comes when investors want their money back, which is precisely what ended the fraud.

Who, What, Why, & How


Bernard Madoff has been a fixture of Wall Street for over 50 years. He is a former chairman of NASDAQ and the founder and owner of the eponymous securities firm. His reputation placed him above suspicion.

In addition to the securities firm, Bernie Madoff ran an investment advisory practice which for years promised and delivered on a stunningly consistent investment strategy. His clients where known to refer to his fund’s return as “Bernie’s Bonds”. He claimed to the public to be employing a highly volatile strategy known as a “Split strike conversion”, yet remarkably churned out nothing but uncannily consistent results. His unregistered fund became the darling of his many long time and wealthy friends and also of the broad hedge fund community who prized his purported consistency apparently above sufficient due diligence. Despite numerous warnings, the fraud was never detected until he simply ran out of money to meet a wave of redemptions.

The Lure

While we do not know the exact duration or mechanics of the fraud it seems safe to say that it had been going on for some time. In 1992, two Florida CPA’s collected funds from investors with the promise of returns of 13%-20%. The manager was Bernie Madoff. The SEC investigated at that time and found all funds to be accounted for. As a current day hedge fund, there is no requirement to register with the Securities and Exchange Commission. Madoff did register in 2006 but he was never examined. Investing in alternatives had promised the myth of absolute returns. No matter the conditions, these managers claimed consistent, uncorrelated, positive returns. And Bernie Madoff was simply doing his part.

The fact that many of his long time friends were defrauded is tragic. The fact that so many sophisticated institutional investors and banks were defrauded is inexcusable. The man used a one man shop for his audited returns, posted unrealistic returns involving a known volatile strategy, and was unregistered: a recipe for fraud or at least a lot more questions than had ever been asked. Had he not been Bernie Madoff, no one would have believed him.

In a broader sense, the promises made by the hedge fund community have not been met. In the case of most, this is not so much by fraud but by reality.

Getting Back to Fundamentals

Investing has never been easy. 2008 is testimony to that. The managers that we employ on our clients behalf are all registered investment advisors. They readily supply all of their annual reports and supporting documentation. We monitor their returns on a daily basis and speak with the individual portfolio managers on a regular basis. Their track records are proven. Each firm uses fundamental research at the company level to establish a universe of potential opportunities and then creates their portfolio of best ideas. There are no guarantees other than to do the best research they are capable of. In addition, securities are custodied and valued apart from the managers. Mechanically, there is no possibility that a Madoff-like scheme could exist. It is certainly a period of time where transparency and liquidity are key portfolio attributes.

• An Old Fashioned Swindle
• Who, What, Why, & How
• The Lure
• Getting Back to Fundamentals