To Madoff or not to Madoff?

By now, everyone has heard the story of Bernhard Madoff, the New York city based investment advisor, who was just arrested for perpetrating a fraud estimated in the billions ($55 billions?) As we look at list of prominent people who have been snared in this web of deceit, including Mortimer Zuckerman and Elie Wiesel, we have another opportunity to examine the consequences of greed, hubris and eventual downfall.

The facts of the story seem fairly clear. Madoff made his initial reputation as a broker/dealer, and he built a business based upon computerization and quick trades for his customers. Somewhere along the way, he also became an investment advisor, though he did not file to officially become one until 2006. He moved in the highest circles of society, and wealthy investors clamored to be his clients. He made himself even more desirable to these investors by turning away several. His allure was not that he delivered super high returns but that he delivered stable and solid returns year in and year out. In effect, he seemed to have found a way to take little or no risk and deliver about 5-8% more than the treasury bond rate. Last week,. he gave away his secret. He had been operating a Ponzi scheme, i.e, using money raised from new investors to deliver returns to old ones. Like all Ponzi schemes, it was dependent on new money coming in. The market collapse of the last few months essentially cut off that inflow, leaving Madoff exposed.

Rather than make this a treatise about bad investment advisors and unquestioning investors, I would like to make a general point about investing in general and professional investors in particular. There are two questions that we can ask about these investors:

a. How much money (returns) did a particular investor make over a period or periods?

b. Why did they make the returns that they did?

As individuals, we are drawn to the first question and there are services that report these numbers in mind-numbing detail. Morningstar, for instance, has returns on every mutual fund in the US, going back in time. Others then build on these numbers: the funds themselves advertise with evidence of superior returns and ranking and reputations are built on past returns. The second question, however, is viewed as intellectual and in some cases, as academic, and seldom gets answered seriously. If we want to entrust our money to a professional, though, we need both questions answered well. In other words, I not only need to know how much you (as a professional money manager) have made over time but also why you made this return: was it superior information, your analytical ability or your trading skills? Using the language of corporate strategy, I would like to know what your competitive edge is and how you plan to maintain it.

 Any investor asking the second question about Madoff would have uncovered red flags. The man was not (and never claimed) to be a sophisticated number cruncher and he clearly did not enunciate an innovative investment strategy. The only potential advantage that he might have had came from his access to the trading data of investors (through his broker/dealer firm) and front running (trading ahead of) his brokerage clients. That, of course, is illegal and would eventually be uncovered. In other words, there was no basis for his solid, stable returns. He was either lucky (but that is tough to pull off over 30 years) or committing fraud. Last week we found out the answer.