Throughout history, people have actively pursued their desires, sometimes to their own detriment.  The allure of Eternal youth, promises of instant success, and attractive Nigerian investment schemes have all been used by cunning con men repeatedly.

Bernard Madoff sold a different fantasy – one of investment performance that only goes up. He exuded the appealing elements of mystery, elitism and exclusion. Not everyone was allowed to invest. And there were certain rules to obey; don’t ask too many questions, and don’t tell anyone you have invested.

Bernard Madoff is currently under house arrest in the US on a $10 million bond. The Securities Investor Protection Corporation (SIPC) has stated that the total loss will not be known for six months but estimates are between $US37-50 billion.

There are lessons we can all learn from this situation. Perhaps if appropriate due diligence had been performed and relevant research processes understood, a lot of this financial pain could have been avoided or at least limited.

Research exposes false glamour
Investors are often unable to devote the time necessary to do all required research on the universe of investment managers. For the unwary, this creates the risk that untrained, under-resourced investors could end up in trouble. And while it may not be on the audacious scale of a Bernard Madoff, the relative cost can be just as huge.

Researching investment products is a complex full time job. This is one reason why many advisers delegate this important process to the experts. As well as being more likely to deliver a better risk-adjusted return, it massively reduces ‘headline’ risk.

If it sounds too good to be true it usually is
On face value, Madoff appeared to pass the reputation test with flying colours; he was chairman of the board of directors of the NASDAQ Stock Market and at a New York hedge fund conference in 1999, attendees named him their most respected manager.

However, experienced research teams are likely to have delved deeper, examined Madoff’s investment strategy and performance record, and perhaps raised some of the following concerns:

•    It was impossible to replicate his returns: Madoff’s trading strategy return never varied in up or down markets, he won all the time. This doesn’t correlate to the real markets. 

•    Inability to implement the stated strategy: Research analysts normally perform liquidity and transaction cost analysis. For Madoff’s strategy, there was insufficient market breadth and depth to implement the trades necessary to manage a $US30-$50 billion portfolio.

•    Unusual business model: While hedge funds were earning up to 20% profits, Madoff was content to earn commissions only. He charged no fees for money management which does not make business sense. Why would Madoff leave so much money on the table? 

•    Secrecy versus transparency: While most funds brag about how much money they manage,

Madoff wanted to keep his fees and FUM secret. He would politely request that investors not reveal that he managed their money.

These issues should have set off warning bells. As advisers well know, when you are charged with a fiduciary responsibility to manage other people’s money, transparency is not negotiable.

Compliance and risk management
This is an area that is lacking in glamour and mostly undervalued, that is until something goes wrong. Investigations should go into great detail on an investment manager’s back office controls and systems prior to appointment, and cover areas such as: trade practices, directed brokerage, order execution, aggregation and allocation of transactions, pricing of securities, reconciliation with custodian’s records, mandate compliance and setup, proxy voting policy, licensing, code of conduct and monitoring of staff.

In the case of Madoff, the lack of an external custodian, used to independently value the portfolio, would have been a potential red flag. All major investment firms use custodians for safe-keeping of their listed securities. By not using a custodian, it was possible for Madoff to create any security prices he liked to value a portfolio at month-end.  

Madoff’s tiny three person audit firm should have also raised questions. Typically managers who manage $50 billion use one of the four global accounting firms.

The Devil is in the detail
A devil’s advocacy or independent review is a key part of any plan to safeguard biases. Such biases can be counteracted by exposing the decision maker to a different take on the issues.

An independent review panel can test the logic of the investment recommendation and the robustness of the due diligence process. 

The importance of extensive, thorough and expert research cannot be underestimated. It can identify issues, alleviate concerns and helps to mitigate potential disaster. The old adage bodes well here "If it sounds too good to be true, it usually is!"

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