Three Lessons from the Bernie Madoff Scandal

This summer, HBO released The Wizard of Lies, a film adaptation of Diana B. Enriques’s New York Times bestseller about Bernie Madoff. Good movie. Good book. But Madoff’s life has been well chronicled since 2008.

While watching the film, I was less interested in the insights into his character than the lessons for investors considering perfectly legitimate investments from perfectly legitimate organizations.

I found three.

1. Don’t mistake a sales pitch for due diligence.

Even today, there are lingering questions about Madoff’s feeder funds. Was their due diligence that bad? Or were they in on the take? I express no opinion. But last year, while I was researching a nonfiction book, “Sam” (not his real name) told me about his firm’s near miss with the wizard.

During the Madoff reign of plunder, Sam headed up wealth management at a prestigious boutique investment bank. However anecdotal, our conversation raises questions about the quality of manager selection throughout financial services.

“We did our due diligence on Madoff and didn’t offer his fund on our platform,” Sam said.

“Why, what did you discover?” I asked.

“Nothing,” Sam replied. “We wanted in. I think he was softening us up before making the call and saying he found a spot and could squeeze us in. But Madoff confessed first.”

During our conversation, Sam admitted that profit incentives blinded his firm to the warning signs of fraud. His company got lucky. As did its clients. They all missed the muck. But there’s a bigger takeaway here: It is impossible to compartmentalize bad due diligence. If our industry cannot spot fraud, how well can we detect issues like style drift? Or anticipate the exodus of gifted stock pickers who leave to set up their own shops?

These problems are not criminal. Nor are they hard to spot. Investment firms should notice them through monitoring and regular due diligence. But just as feeder funds missed Madoff’s treachery, I wonder whether investment firms that sanction pay-to-play arrangements — those that receive compensation for promoting outside money managers — will miss the leading indicators about future mediocrity while their clients pay the price.

Just sayin’.

2. Beware the “Exclusivity Pitch.”

Madoff used exclusivity as bait. Investors were begging to gain access to his Ponzi scheme. So were sophisticated wealth management firms, as my story about Sam illustrates.

Sure, Madoff’s steady, reliable, never-miss, double-digit returns might be the reason why investors ignored the early warning signs that his performance was fake. But that said, these “exclusivity pitches” prey on internal emotions that cause investors to drop their guards and sometimes make bad decisions.

Take hedge funds, where exclusivity is one part sales pitch and two parts securities law. Estimates vary. But the super rich invest as much as 8% to 18% of their wealth in hedge funds. The question is why given the performance hurdles created by the pricing orgy we know as “2-and-20.”

Let’s say an index returns 10% one year. Just to equal this performance, a hedge fund — which charges a 2% fee on assets under management (AUM) and keeps 20% of annual profits — must deliver gross returns of 14.8% as the table below illustrates:

An outperformance of 48% [($14.80-$10) / $10] is a big hurdle in any given year, and my analysis doesn’t account for additional hurdles created by tax-inefficient trading strategies.

For that matter, sustained outperformance is a big hurdle no matter what the amount. The SPIVA U.S. Scorecard states: “Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.” And according to the S&P Persistence Scorecard, “relatively few funds can consistently stay at the top.”

In general, SPIVA’s findings pertain to an outperformance of any amount. So why would perfectly rational investors agree to pricing structures that create 48% performance hurdles for adding value? (If you say, “Correlation,” I’m underwhelmed. But let’s save that discussion for another day.)

In December 2015, while conducting research for a nonfiction book, I stumbled over one possible explanation. Just before Christmas, I wrote to a “Who’s Who” of financial crime — all men, all behind bars, about 25 convicts in total.

The names ranged from Bernie Madoff to Allen Stanford to Nevin Shapiro. I specifically asked them if they target certain personality types and, in a more diplomatic manner, how investors can spot and avoid people like themselves.

Madoff did not respond. But I did hear from Barry Minkow who, among other crimes, took a Ponzi scheme public (ZZZZ Best). In his reply, he described the power of making individuals feel like they are a member of an exclusive group:

“The perpetrator will make the target feel special, like the ‘average’ doesn’t apply to them because they are better than average and are therefore entitled to a ‘special, higher rate of return’.”

No, I am not saying hedge funds are frauds. I simply believe the lesson from Madoff is that “exclusivity” is a red flag for both investors and the investment professionals who serve them. The wealth management industry would fare far better if the merchants of exclusivity focused on transparency instead.

3. Numbers are great liars.

Madoff’s statements were bogus. So were his trade confirmations. His compelling returns were fake. But I see parallels to internal rate of return (IRR) calculations. They are a completely legitimate mainstay of wealth management, often compelling, and sometimes deceptive.

Consider, for example, a private equity fund that delivers an IRR of 40.16% based on the following cash flows:

The IRR formula reinvests distributions in all five years at the IRR rate. Which, in all candor, I find difficult to wrap my brain around. So I made the following table. It compounds $100 at 40.16% and compares the future value of this calculation to the future value of the private equity fund’s annual year-end distributions compounded at the same rate. In each case, the numbers total $540.96 by the end of year five.

Source: Methodology based on a 2004 paper by McKinsey & Company: “Internal Rate of Return: A Cautionary Tale.”

Problem.

Nobody has $540.96 at the end of five years. If an investor receives these distributions and earns 3% while searching for “the new new thing,” the future value is $262.27. Not $540.96. The annualized return on $100 is 21.27%.

Nice. But it is a completely different story from the IRR, which continually reinvests cash flows at 40.16%.

Now What?

On one level, these lessons from Madoff serve both investors and financial professionals alike. They flag areas of investment pitches that bear further scrutiny. For professionals, they especially illustrate the importance of transparency and thorough, easy-to-understand explanations.

But on another level, the three lessons suggest more reasons to consider low-cost index funds. These funds are hardly exclusive. The world is vetting them constantly. So long as investors reinvest dividends and other cash flows back into the funds, the annualized returns are a real measure of investment performance: What you see is what you get.

And what’s better than that?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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