Detecting Bernie Madoffs

Last week the New York Times ran an installment of its Wealth Matters column entitled How Do I Know You’re Not Bernie Madoff? Literally, it’s an easy question to answer. (Because I’m not in prison.) But figuratively it’s anThree_Card_Monte crop ZioDave important question for which everybody with money to invest should have an answer.

The column starts out with a brief interview with a private wealth manager with the impossibly appropriate name of Tony Guernsey. (A posh off-shore banking center?) And there’s a picture of the fellow. He looks exactly as Ralph Lauren would have him look: tortoise shell glasses, chalk stripe suit, and chin thoughtfully rested in right hand. In the foreground there is (I swear I’m not making this up) a small red flag.

Tony Guernsey has been in the wealth management business for four decades. But clients have started asking him a question that at first caught him off guard: How do I know I own what you tell me I own?

That’s an important and basic question. It is a wonder that it took four decades for clients to start asking, but I suppose the glasses and expensive suit go a long way.

Besides being basic, it is a question that has, or ought to have, a fairly specific answer. You know that you really own what your advisor says you do because the custodian of those assets, which is unrelated to your advisor, sends you statements to that effect and those statements are audited by a reputable firm unrelated to both the advisor and custodian.

As a general matter of principle, there should be a clear separation between the guy who makes the investment decisions and the outfit that holds the assets. It is a lot harder to steal your client’s money if you can’t touch it.

The Wealth Matters column takes a while to get around to making this point and then only obliquely. And there is an even more important answer to the question in the title that is ignored completely.

It is often said that Madoff’s claimed returns were too good to be true. Indeed, that was one of the key arguments made by Harry Markopolos when he tried to get the SEC interested in Madoff. They didn’t get it, and even with the benefit of hindsight most observers of the case seem to miss it also.

The point of too good to be true is not merely a cynical pessimism that great returns are unlikely to happen. The point is that if Madoff was really getting the sort of returns he was claiming, a steady 12% a year with only one or two down months per decade, he would have no need for outside investors. He could have just borrowed the money at rates much lower than 12%. Since he didn’t, a person should have been able to conclude that he was either a) an idiot b) uninterested in making money c) remarkably generous to strangers or d) a crook. The correct answer was d.

The Madoff scam is special not because of how it worked or the warning signs that went ignored. It is notable because of its sheer size and the wealth (and presumed sophistication) of its victims. If you are reading about Madoff and thinking that it is an amusing story about very bad things that can happen to people a lot richer than you, you are being quite foolish.  Most investment scams, Ponzi and otherwise, target those of relatively modest means.

So when your investment advisor convinces you to let him make investment decisions for you, make sure he has no direct access to the money. And when somebody offers to let you in on the ground floor of a sure fire winner, ask yourself why your money is needed at all. Because the correct answer is often d.

[Photo: ZioDave]

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