Tough Minded Investment Manager Analysis

That’s Mr. Ponzi to you.

In a Ponzi scheme, investors are paid out of money committed to the fund by subsequent investors, rather than from real investment earnings. Thus, investor number one’s "earnings" are not really earnings at all. Investor number one’s earnings are really the investments or, rather, the money commited by later investors, by, say, investors two and three. In turn, investor two’s earnings are really the investments made by investors four and five and so on.
 

Put baldly, it is hard to understand why anyone would fall for a fraud that stupid. The nasty details are always kept secret, of course. This suggests that a FOF manager who demands transparency will never become one of Mr. Madoff’s victims, which is true. Unfortunately, from the FOF manager’s point of view, secrecy is not always a completely unreasonable request. To the contrary, for some investment managers, some of the time, it is essential.

In which case, the FOF manager must insure, from the available evidence, that the investment manager is behaving properly or he must take his money somewhere else. Judging by the newspaper articles, the FOF managers who invested with Mr. Madoff did little more than review Mr. Madoff’s track record and promotional material. An investment firm’s promotional material usually reveals its investment logic or lack thereof, which in the case of successful Ponzi schemes usually makes some sense. For example, Charles Ponzi told investors that he was arbitraging international reply coupons for postage stamps. For example, J. David Dominelli claimed to be a currency and commodity trader. These are not unreasonable strategies; an immense amount of money has been earned (and lost) over the years by currency and commodity traders and investment managers arbitraging one type of investment against another.

All other things being equal, the more sensible a fraud’s investment logic, the more money and people the fraud will ensnare. Unfortunately for Mr. Madoff’s victims, his investment logic was relatively sound. Mr. Madoff’s explanations wouldn’t stand up to an English teacher with a red pen and access to the internet, but it was equal in quality to most of the gibberish that passes for investment analysis these days.

Articles in the investment press are thick with excuses. If the point of these articles is to explain why no one or almost no one pointed a finger at Mr. Madoff and screamed, "J’accuse!" then these articles are, on average, correct. None of the available evidence proved fraud. Moreover, without access to the accounting records it is absolutely, utterly impossible to prove fraud.

But an investment manager is not a defendant on trial; he is not to be presumed competent until proven incompetent. To the contrary, an investment manager should always be assumed incompetent until proven competent. Any FOF manager who assumes otherwise is either criminally incompetent himself—or he’s the sugar plum fairy.

Whatever else the banks, brokerage firms, hedge funds, feeder funds, financial advisors and other investment professionals do as part of their due diligence, the very least they should do is ask, "What are these assets worth and who says so?" and then, "Who controls these assets?" It is here, precisely, that those FOF managers who entrusted their clients’ money to Mr. Madoff failed so miserably.

Asking who controls a set of assets is roughly the same as asking who their custodian is. In this case, the custodian was Madoff Securities, which means that every single piece of paper listing asset purchases, sales and values was a product of the people who collected investor money and invested it or, at least, said they did.

Asking who attests to the value of a set of securities is roughly the same as asking who their auditor is. As is well known, Madoff’s auditors turned out to be a small, obscure auditing firm utterly incapable of doing the necessary work. The auditors provided no check at all. With almost no exceptions, the FOF managers never bothered to check who the auditors were.

In my opinion, the FOF managers who signed off on Madoff Securities are all guilty of criminal incompetence. The reader must understand that my opinion is not common on Wall Street and he must understand why. Beyond the obvious, that it is never in a Wall Street professional’s best interest to see what others on the street do as criminal incompetence, there are, at least, two real issues of psychology and evidence here.
 

First, Madoff Securities had a twenty year track record. Many on the street considered this prima facie evidence of competence. When it occurred to these professionals to ask themselves whether Madoff Securities could possibly be a fraud they asked, instead, how Madoff Securities could possibly be a fraud and yet have survived so long. This is not an unreasonable question. If profits aren’t proof of investment competence, then what is? But profits are not proof when the profits aren’t real.
 

In all fairness to the victims, it is hard to overstate how compelling this illusion is. I don’t know a single Ponzi scheme where the people running it actually got away with the money. In the end, the confidence men always fall for their own con. In the end, they all go to jail.

Second, Madoff Securities’ problems were relatively rare. Almost no one in the industry had experience here. How could we have all been at fault, many in the industry argue, when none of us had ever seen this before? Again, this is not an unreasonable question. But FOF manager are not paid to do what they are comfortable doing, they are not paid merely to follow industry practices, they are paid, they are well paid, to do what is necessary to protect their clients’ interest.

The list of FOF managers who were defrauded is long and distinguished. I know some of these managers and when their clients are not present, and especially after a few drinks, they sometimes present an attitude of bitterness, cynicism and outright nihilism that would leave Dick Cheney gasping in horror.