Bernard L. Madoff Investment Securities

Analysis and Commentary

Bernie Madoff operated a classic Ponzi scheme under the cover of an investment advisory business for 40 or more years. Through his firm, Bernard L. Madoff Investment Securities LLC (BLMIS), Madoff took in client assets, transferred client money to his own personal accounts, and mailed out fictitious account statements to hide the ruse. Then, when clients withdrew funds, he used recently acquired capital from other investors to pay out redemptions. From a marketing standpoint, he sold his product to clients as a hedge fund, promising consistent performance regardless of market conditions. Because the stated strategy included both long and short positions, his claim seemed plausible. He rarely met with investors and refused to divulge any information pertaining to the firm’s practices, other than that he used a split-strike conversion investment strategy. To some, the opaqueness about his approach gave him the aura of a wizard who had figured out how to beat the market. As it happens, the split-strike conversion strategy is perhaps the perfect vehicle for selling and disguising a Ponzi scheme.

The most compelling analysis of the Madoff case is the one performed by Harry Markopolos, CFA, years before Madoff’s scheme collapsed. In a series of letters over several years, Markopolos attempted to warn the SEC about what he believed to be serious fraud at BLMIS. His letters to the SEC began in 2000 and became increasingly bold in expressing doubt about Madoff’s operations.

By 2005, Markopolos had detailed his concerns about Madoff’s fund in a letter to the SEC titled “The World’s Largest Hedge Fund Is a Fraud.” Among the many red flags highlighted by Markopolos was that Madoff’s fund reported having earned 16% average annual returns before fees over 14½ years by using the split-strike conversion strategy. Markopolos identified three possible sources of returns in this strategy: dividend income from the stocks owned, premium income from the sale of index call options, and capital gains of the portfolio. Markopolos calculated that for Madoff’s 16% a year in gross returns, approximately 2% would be from dividend income and another 2% would be earned in premium income, supposedly leaving 12% a year to capital gains. However, the purchase of put options (representing the “protection” part of the split-strike strategy) would cost the fund a minimum of 8% per year, thus requiring the gross capital appreciation of the stock portfolio to be 20% per year. If Madoff were, in fact, achieving 20% gross returns per year, then, as Markopolos pointed out, Madoff would have been a legend in the field of investing. Yet—in sharp contrast to such famous investors as Warren Buffett and Bill Miller, who spoke frequently about their views on business and investing—Madoff was evasive about his business and investing strategies.

Beginning in 2008, Madoff began to receive a massive amount of redemption requests from clients who were scared by the global financial crisis. In preceding years, redemptions were generally less than the new fund flows into BLMIS, so these requests could be fulfilled and the Ponzi scheme remained intact. In early December 2008, however, according to Madoff’s own account, the firm faced $7 billion in redemption requests. In October 2008, Madoff had reversed his long-standing policy of limiting new contributions to his fund. According to numerous accounts, after having exhibited calm, emotionally detached behavior for years, he had suddenly become pushy and demanding in dealing with people he wanted to bring in new assets.

On 9 December 2008, Madoff allegedly told his brother Peter about the fraud. The next day he told his sons that his business was one big Ponzi scheme, and Madoff’s sons turned him into the FBI. On 11 December 2008, Madoff was arrested by the FBI and charged with securities fraud. On 12 March 2009, Madoff pleaded guilty to 11 counts of securities fraud. He ultimately received a sentence of 150 years in prison.

Even after the courts have spoken, many questions linger about Bernie Madoff and how he managed to deceive people for so long. Unfortunately, key aspects of the story remain incomplete. Nevertheless, even without the complete story, valuable lessons can be learned from the case. Setting aside the mechanics of the fraud, the critical lessons for investors and investment managers concern (1) realistic standards for evaluating investments, (2) due diligence, and (3) diversification.

First, in making investment decisions, investors need to ignore the appearance of success and the popularity of an investment and emphasize realistic expectations for the investment strategies. Bernie Madoff created a reputation for reliability and respectability for BLMIS and for himself personally over several decades. His brokerage and proprietary trading firms were legitimate, innovative, and well-respected businesses. Madoff earned praise from the SEC during the market crash of 1987 for keeping his doors open when others were closed (made possible by the fact that his clients’ assets weren’t actually invested in the crashing market!), and he was chosen to serve as nonexecutive chairman of NASDAQ. He was charismatic and convincing (as demonstrated in a televised interview with ABC News in 1992 in which he discussed how difficult it would be for a fraudulent investment firm to elude detection by regulators).

Many people look to social and material cues of respectability and assume that if others have come to a positive conclusion, they are safe to feel the same way. Exploiting this natural tendency, Madoff hid behind his reputation and masked his deceit for an incredibly long time, and many investors paid a huge price as a result.

Even though people repeatedly raised questions about how Madoff was able to achieve the returns he claimed, no one apart from Markopolos, apparently, invested the time and resources necessary to carry out quality due diligence on Madoff’s purported strategy. Yet, we know that if something seems too good to be true, it probably is. For instance, Madoff’s purported options trading activity vacillated between 7 and 65 times the entire trading volume of the market for the specific contracts they were allegedly trading (Carozza 2009). Madoff’s returns also exhibited a Sharpe ratio that ranged between 2.5 and 4.0 for 15 years in a row—an extreme outlier, to put it mildly. Investors should focus on what makes sense and seek confirmation of those assumptions. An investor must understand the strategy, history, and business structure of the target investment or manager. When dealing with a particularly complex investment, investors need to understand the general return characteristics that accompany that accompany that strategy.

From a behavioral perspective, Madoff was a master con artist. He didn’t just play to people’s greed, he also played to scarcity and ego. The high returns and low risk brought prospects in the door. But Madoff sealed the deal by playing off their emotions. He created the aura of exclusivity about the product, telling prospects that he wasn’t taking new money. Inevitably, he would find some trait or characteristic about the person and flatter them. As Markopolos said [of Madoff’s approach], “Because I like you, I’ll give you access and allow you, and only you, to invest” (Carozza 2009). This tactic made those investors feel lucky to get in the club, so to speak. A compliment is one thing. But a compliment from someone of Madoff’s outward success and stature appealed to the ego. And the access that Madoff permitted then validated the compliment. Pride is a powerful and often dangerous emotion. Often, we are not even aware that we are being prideful. As investors, we have a duty to ourselves and our clients to be mindful of pride and the grievous mistakes to which it can lead.

Clearly, any due diligence performed by Madoff’s investors was inadequate. That said, even the most rigorous due diligence has limits, and not all investors have the ability to perform a sophisticated analysis of a potential investment. So, investors need to allow for the possibility of being conned by the target of the due diligence and use adequate diversification and risk mitigation in response. In short, never put all of your eggs in one basket. In addition, don’t let your financial manager be the physical custodian of your assets. Separating these two functions will provide some protection against outright fraud.