Lesson from the Bernie Madoff Ponzi Scheme

As more and more news comes out about Bernie Madoff and how he managed to defraud many very smart people out of billions of dollars, it is useful to ask a simple question; what should we learn from what happened? From my perch the answer is very basic.

The few people who avoided Madoff’s funds did so due to doubts over the highly suspicious consistent returns he claimed (many concluded he could not produce such steady profits from the strategies he claimed to be using). They avoided disaster because they lacked information and without knowledge of what their money was invested in, they were not comfortable investing with Madoff.

The others were not as fortunate, but it begs the question, does it make sense for anyone to invest money with a money manager if they are forbidden from knowing where the money is invested? I don’t think so. I know I certainly could never look one of my clients in the eye and ask them to stop receiving account statements so their holdings could be secret. Trusting someone, as Madoff’s investors have learned the hard way, is not a good enough reason to put a blindfold on and hand someone millions of dollars.

Now, many hedge funds will argue that disclosing their holdings strips them of their “edge” since many people will simply mimic top managers’ trades and thereby reduce returns for the people coming up with the ideas. To curb this concern it is certainly reasonable to allow a slight delay in the reporting of actual holdings to ensure that a hedge fund manager can establish a full position before disclosing it to the public. You could also have investors sign a contract saying they will not act on or alert anyone to the nature of the fund’s investments.

Regardless, if you are investing in any fund that does not adequately disclose where your money is allocated, I would strongly consider ceasing such an investment. It sounds obvious to many, but given what has transpired recently, it warrants mention.

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2 Thoughts on “Lesson from the Bernie Madoff Ponzi Scheme

  1. milt tomkins on December 31, 2008 at 2:37 PM said:

    great post….I dont think I would care about each trade myself…once I turned over the money…of course I want statements… in researching more about hedge funds I came across a few books that were fascinating ..honest, and informative…..Hedge Fund Trading Secrets Revealed by Robert Dorfman… and Confessions of a Street Addict by Jim Cramer….both these books take you on a great ride about hedge funds and how they make money. I learned about this secret society than I ever would have imagined.

  2. shepherd on January 5, 2009 at 2:00 PM said:

    Chad,

    Small point, but I’d add that if you don’t know how your money is being invested, there is no way you can properly diversify your holdings.

    I also don’t think most hedge fund managers gain much by their secrecy. There are too many for them all to be geniuses. Many of them simply magnify ordinary returns with leverage. Which is a great thing to do, so long as you’re doing it with someone else’s money.

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