The Bernie Madoff scandal has investors newly terrified of money manager fraud. But fraud is actually not all that hard to avoid - the real lesson goes deeper than that.

"Madoff with ya money."

Of all the articles covering the scandal, that title from the Financial Times sums it up best. The opening of the piece is pretty good too:

Nothing stupefies like money. Even the savviest investors tend to look the other way when extraordinary returns are being made. This unfortunate human trait is the fuel behind speculative bubbles and the magic behind all financial scams.

No one, it seems, has exploited this as blatantly in recent times as Wall Street bigwig Bernard Madoff, a former Nasdaq chairman arrested this week for allegedly running the biggest dollar Ponzi scheme of all time.

The scale of the fraud is staggering. Tens of billions have been lost - perhaps as much as $50 billion over many years. Wealthy families, numerous charities, and even college trusts have been all but wiped out.

The Palm Beach Country Club, where Madoff recruited many of his victims - er, investors - is said to be in a panic. Perhaps the largest private victim is Carl Shapiro and family, who had known Madoff for 50 years and had $545 million invested.

A number of large players were caught in the scam too. Britain's HSBC Bank may have lost as much as $1 billion. Banco Santander had more than $3 billion in exposure through its money management arm. Even the State of Massachusetts had skin in the game... the list goes on and on.

The Biggest Red Flag

There were plenty of red flags, but Madoff's reputation gave him a pass with investigators and regulators alike.

As far back as 1999, forensic whistleblowers had reported Madoff to the SEC as a fraud. Barrons ran an article in 2001 openly wondering how Madoff did it when no one else could. In hindsight there were many small things... skeptics had been asking questions for years, but they were always waved off.

The biggest red flag of all, from a trading point of view, was the silky-smooth consistency of Madoff's returns.
The steady gains with virtually zero losses were exactly what enthralled Bernie's clients, when they should have been warned away.

Charles Gradante, founder of hedge fund consulting firm Hennessee Advisors, is one of the skeptics who steered clear.

"He only had five down months since 1996," Gradante notes. "There's no strategy in the world that can generate that kind of performance. But when people would come to him and say, 'How did I make money this month?' he didn't like it. He would get upset with people who probed too much."

In the real world, returns just don't go up in a nice straight line. Mother nature is messy... markets are messy... and nothing works 100% of the time. But people will pay big bucks to avoid facing up to that truth.

Some of the biggest losers in this mess will prove to be the "funds of funds" - investment pools that allocate money to traders on behalf of their clients. The funds of funds who put billions with Madoff all claimed to be practitioners of deep due diligence. Now they look like useless fools.

On one of my trips to New York two years or so ago, I asked a fund of funds manager what their ideal trader looks like. "The best guys are the ones who deliver that steady 1 to 2 percent a month like clockwork," he told me.

I thought the idea was dangerous even then, and wrote as much to readers that it would all end in tears. But a clockwork 1 to 2 percent is what the funds of funds wanted... so that's what Bernie Madoff delivered.

Variations on a Theme

When I first read of Bernie's loss-defying equity curve, four other exercises in smoothing folly came to mind:

• Ralph Cioffi and Matthew Tannin, managers of the Bear Stearns "High Grade Structured Credit Strategies Fund" and, even more laughably, the "High Grade Structured Credit Strategies Enhanced Leverage Fund." These guys made money every month for something like 40 months in a row. Then they blew up. Then Bear Stearns blew up.
• Jack Welch, the hero CEO of General Electric whose legacy was later tarnished by the reveal of his "massaged earnings" technique. Under Welch, GE managed to hit growth targets with bull's eye precision year after year after year. The Street loved it... later it was revealed that Welch had more than a little help from GE Credit (the creative finance arm) of the sort that would be frowned upon today.
• Victor Neiderhoffer, a naked options seller who blew up his clients not once, but twice within a decade. For much of the 1990s, Niederhoffer was rated the top hedge fund manager in the world... until the Asian financial crisis blew him up in 1997. A few years later Vic got back in the game... again posted award winning returns... and blew up in 2007 for a second time, to the tune of 75%.
• Long Term Capital Management, perhaps the most arrogant hedge fund of all time. LTCM had not one but two Nobel laureates on staff. Their strategy was self-described as vacuuming up nickels all over the world that others weren't smart enough to see. What they were really doing, it turns out, was snatching nickels from the path of bulldozers.

In all these cases, the strategies in question worked smoothly and superbly for quite a long time - until one day they didn't. It's like the old trader's saying... you can take your volatility in small doses, or you can take it all at once. Which one is up to you.

Fraud Prevention is the Easy Part

In keeping with human nature, people will likely draw the wrong lesson from the Madoff fiasco. They'll focus on the fraud part - the importance of making sure whoever manages their money is not a charlatan.

This is important obviously. But the fraud aspect is actually one of the easiest things to prevent, once one learns to pay attention.

There were many working parts to the setup, but one was absolutely vital. Madoff was only able to pull off the scam because he cleared his own trades. He acted as his own broker-dealer and used a three-person accounting firm holed up in a strip mall to handle the firm's books. When you're running $17 billion in assets, that's insane.

Any normal hedge fund would have been set up with a "prime broker" - a respected third party custodian to handle the assets and book the trades. That would have made it impossible to commit fraud the way Madoff did. When a legit third party holds the assets, there's no way to falsify the results.

This is probably why Madoff never registered as an outright hedge fund. He knew that doing so would prevent him from carrying out the scam in full.

If Madoff's returns were real, he could have made hundreds of millions of dollars in "2 and 20" incentive fees every year, instead of leaving those fees on the table and merely collecting commissions. But as a full-blown hedgie, his books would also have been subject to more scrutiny... so Bernie took a pass on hedge fund status in order to maintain a low profile.

In passing up those huge fees, Madoff's lack of greed was the dog that didn't bark. Funny old world innit.

And furthermore in that respect, it's ironic that hedge funds could get the most political heat from this whole deal. If anyone should be tarred and feathered, it's the SEC, who had ample reason to check out Madoff through the years and never did.

Know the Risks

The more subtle-yet-vital lesson from this whole Madoff fiasco, in my opinion, is the importance of understanding the strategy.

If you can understand how a trading or investing strategy makes money - the guts of how it really works, good and bad, warts and all - then you can also understand the risks.

The most robust trading and investing strategies are logical. They don't take rocket science or complicated math or a PhD in physics to understand.

And yet, Madoff's investors didn't apply this simple rule of thumb. They took his explanations at face value, even when those explanations didn't make sense. The strategy was laid out in simple fashion, but the returns literally didn't add up.

A few savvy investors, knowing the official line had to be bogus, figured Madoff must have been doing something he didn't talk about... maybe even something illegal... but they figured it was no problem as long as their profits were safe. Call that the most cynical trade of all.

My one hope from all this is that the Wall Street love affair with silky-smooth returns and artificial stability comes to an end (or at least goes into remission for a good long while).

On a larger scale, we run into the same type of "smoothing" problems when our government tries to iron out the natural fluctuations in a free market economy. And what bigger Ponzi scheme exists than social security... but I'd better end here before going too far down that road.

The sooner we realize there's no free lunch - and no such thing as investing without healthy ups and downs - the better off we'll be.

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