Madoff - how to protect yourself?

[cyclone6]

I've got a lot of money invested in both of John Hussman's funds (HSGFX and HSTRX). I enjoy reading his weekly commentaries, and like the idea of having some of my money professionally managed.

How in the world can someone - anyone - protect themselves from a Madoff type disaster? Isn't anybody who holds an actively managed fund completely at the mercy of the manager?

I'm not attempting to imply in any way that Hussman is anything but a stand-up, honest individual. I like to think that he is. I hope he is.

Because I couldn't imagine waking up one morning and - not finding out that my fund lost 3% yesterday - but that the shares are all worth zilch because there was massive fraud.

Damn scary.

 

[Running_Man]

The most important way to protect yourself is to find out who exactly is auditing and certifying his funds. Madoff had a one person firm auditing his figures. That is a giant red flag. If the audit firm is not well known, you have to question why is the investment team using a cheap accounting firm.

 

[ziggy29]

Madoff had a one person firm auditing his figures. That is a giant red flag. If the audit firm is not well known, you have to question why is the investment team using a cheap accounting firm.

Then again, Arthur Andersen was a pretty well-known firm when they were auditing Enron's books...

 

[audreyh1]

As shocking as this is, I see this as a reflection of hedge funds - which I never touched with a ten foot pole anyway, mainly because I thought their fee structures outrageous on top of their "secretive" nature - and not of your basic traditional mutual fund.

I suppose it's possible for a mutual fund to falsely report every quarter what it actually owns, but given the paperwork requirements and the oversight by boards and fund companies, etc., it still seems unlikely to me that a fund manager can pull off massive fraud for personal gain.

Not that there haven't been some ethics violations in mutual fund companies. I got the heck out of the last of my Strong Funds when I found out about their shenanigans many years ago. IMO high fund fees are a red flag for lower inclination to treat investors well, and funds where the managers or fund company are also large holders seem safer than most.

Unfortunately, all of this just makes even more retail investors flee the markets. I wish (useless wish of course) that the current SEC had had interest in protecting the retail investor, keeping the playing field "level", so to speak, instead of changing rules to favor the hedge funds, large speculators, and investment banks.

The investment banks are broken, the hedge funds are broken, and all that is going to be left is the retail investor and pension funds. But they have been burned so badly by Wall Street that Wall Street is going to suffer for a long time. I wonder if we'll ever hear them moan "But what happened to the retail investor?". I guess it's just desserts, but it's a real pity all the same.

Audrey

P.S. Good point(s) about the audit firm.

 

[riskadverse]

I only lend large sums of money to those with whom I have a good feeling of "trust". I do quite a bit of research to gain that "trust" feeling, and monitor it after I have made that investment. At the first sign of trouble, I usually lose this "trust", and shortly thereafter I withdraw the loan. Sadly, now I'm starting to lose my "trust" in the US government.

 

[BunsGettingFirm]

Yes, you can avoid the type of problem by not being a high-net-worth or accredited investor. Well, I was well on my way. After the latest bloodbath, I can put the worry of accidentally investing in a bad hedge fund to rest.

 

[Dreamweaver]

To me, it seems two things really stand out that will protect you. Only invest in funds that:
1. are transparent
2. that you understand

If you read some of the stories on this fund, investors either could not access information on the fund because it was not transparent, or could not understand the strategy that led to such consistent returns. There tend to be good reasons why information is kept not transparent or not understandable, which often involve getting ripped off or fraud.

This parallels another famous investor's strategy, Warren Buffett, as he recommends only investing in things you understand. He didn't understand tech stocks during the bubble, and of course that turned out to be one big rip off as well. The old saying of if it sounds too good to be true...

 

[chinaco]

This is probably another one of those situations where he was not a crook in the beginning, but took too much risk and had one big loss early on and covered it up (cooked the books) thinking he could make the money back... taking ever bigger risks until he lost it all.

Where were the independent auditors? Apparently this was going on for some time. This is a case of someone having too much control with no checks built in. It is not uncommon for a small business to have this happen... but this guy was given large sums of money.

Classic case of lack of oversight by regulators and independent audits. Other people in that organization had to know something was going on.

This is really no different than the MBS, Credit Default swaps, Loose Mortgage rules, Rating Agency Corruption... People inside had to know.

IMO - Several other people in that organization should go to jail for being a part of the corruption. If one worked to enable it and further it... they are part of it. Pleading ignorance is not an excuse for deflecting the culpability of be part of a criminal enterprise.

 

[Zoocat]

How to protect oneself? That's a good question.
With a person like Madoff who is obviously a sociopath with no conscience and who can compartmentalize expertly, a normal person is quite vulnerable.

Everyone, it seemed, was fooled by this little man behind the curtain, who like the Wizard of Oz pulled a few levers and waved his hands around and created an illusion with smoke and mirrors that many, unfortunately, were drawn into.


What times we live in.

 

[Architect]

ZING! lol ...

Then again, Arthur Andersen was a pretty well-known firm when they were auditing Enron's books...

I remember laughing at the Andersen reference in "Cashing in on the American Dream: How to Retire at 35" ... they WERE the gold standard.

This is one reason I like a Taleb type barbell strategy, 90% in individual buy/hold bonds (Treasuries, excepting periods like this when short Treasuries don't return anything), and 10% speculated in stocks. Pretty hard to blow up.

After all, what do we get for paying our fund managers so much money? Not much in my small opinion. I had my entire 401k in a PIMCO bond fund this year, and 'enjoyed' paying them to make poor investing decisions (Fannie/Freddie) while I made +35% by my bond strategy.

 

[stephenandrew]

Jason Zweig from the WSJ addresses this very point

In today's Wall Street Journal, Jason Zweig addresses this very point. Basically, his perspective is that these investors only have themselves to blame. If his facts are correct, I would agree.

How Madoff Made People Look Dumb - WSJ.com

 

[haha]

Bernie Madoff has the same story almost every big time successful swindler has. High living, good returns, charismatic personality, great community reputation and as others have said no transparency and no verifiable controls in place. Usually all he has to accomplish is to get some prominent people to invest and donate to and get onto boards of prominent charities. Very few prospective investors will look beyond this. Humans are generally programmed to fall in behind prominent or prestigious people, it's in our genes. Though likely not in the genes of the deviants who hang out here.

But realistically, how many of us pay very careful attention to what controls may be in place in the funds or companies in which we invest? Or how many of us who have financial managers are sure that the statements we recieve are legit?

 

[brewer12345]

Madoff's mess was easily avoidable for anyone who did even the most basic due diligence on control processes, auditors, etc. Just about every red flag in the book was present for anyone who bothered to look.

Dunno about you, Ha, but I look very carefully at all conflicts of interest, control standards, board composition, who auditors are, etc. Not that you can catch everything untoward that way, but it at least keeps you out of the obvious messes.

 

[haha]

Dunno about you, Ha, but I look very carefully at all conflicts of interest, control standards, board composition, who auditors are, etc. Not that you can catch everything untoward that way, but it at least keeps you out of the obvious messes.

You know, I always read the Proxy statement, and of course any prospectuses and annual and quarterly filings. I rejct companies with horribly over-reaching managements. Except for a few, they all overreach; so it is just a matter of degree.

But some of these things (not of the Madoff level) are not easy to spot. In the past 3 years, one of my companies suffered high level embezzlement, and another fired an executive for taking kickbacks on leases. Not anything that was fatal, or even extremely stressful to the operations, but unsettling nonetheless.

I am returning to Graham's idea of margin of safety- and one margin I want to try to leave is a margin for missed information, deliberate fraud, and historically low probability events. High debt propositions are inherently unstable, even if carefull analysis suggests that all is copacetic.

Brewer, a question that you can likely answer-what is to prevent a CEO from buying a big slug of his stock in the open market, reporting the buy on Form 4, but actually taking the economically opposite position by being long default swaps? Swaps transactions are not reportable at all, are they?

Ha

 

[mickeyd]

This sums it up pretty well.

 

[brewer12345]

Brewer, a question that you can likely answer-what is to prevent a CEO from buying a big slug of his stock in the open market, reporting the buy on Form 4, but actually taking the economically opposite position by being long default swaps? Swaps transactions are not reportable at all, are they?

Ha

I haven't sat for any Series XXX exams, but as far as I understand things, insider trades in any securities issued by a company (stock, bonds, preferred, derivatives, etc.) are reportable on form 4. I have seen insiders enter into total return swaps on an equity and the arrangement was reported on form 4, so I don't see why another OTC derivative (CDS) would not be reportable.

 

[haha]

Thanks.

 

[ERD50]

But realistically, how many of us pay very careful attention to what controls may be in place in the funds or companies in which we invest?

Maybe I'm being naive here, but is there someway that a SPY ETF could hold some real and significant risk beyond the underlying security risk? Or an index bond fund at Vanguard or Fidelity?

No, I have not researched those controls, should I? What would I look for?

Again, maybe I'm being naive - but those investments strike me as being in an entirely different universe from some hedge fund, where (apparently) you say - "Hi! You seem like a smart guy - here's a bunch of my money - do something with it to make me rich!".

Isn't that pretty much what the people who invested in his hedge fund did?

-ERD50

 

[brewer12345]

With mutual funds you have the benefit of the many investor protections baked into securities law and generally enforced pretty tightly. But you still have to pay attention in part because the prospecti are generally written to allow about anything permitted by law. As an example, imagine my surprise a few years ago to see that my MSCI EAFE index ETF (EFA) had written CDS protection (taken credit exposure) on GMAC and Ford motor credit.

As far as hedge funds go, the wiser investors do lots of due diligence but there are plenty that pretty much say "take my money and do something with it." Even those that do go digging are taking their chances, given the lack of securities law protections.

 

[Nords]

I wish (useless wish of course) that the current SEC had had interest in protecting the retail investor, keeping the playing field "level", so to speak, instead of changing rules to favor the hedge funds, large speculators, and investment banks.

Yes, you can avoid the type of problem by not being a high-net-worth or accredited investor. Well, I was well on my way. After the latest bloodbath, I can put the worry of accidentally investing in a bad hedge fund to rest.

I think the accredited-investor rules provide enough protection without getting in the way of investing.

This parallels another famous investor's strategy, Warren Buffett, as he recommends only investing in things you understand. He didn't understand tech stocks during the bubble, and of course that turned out to be one big rip off as well. The old saying of if it sounds too good to be true...

Two comments on that--
- When Buffett formed his partnerships, the partners agreed to not know what he was investing in. (These limited partners were friends, family, and a few who'd taken his classes or knew his reputation.) They actually signed papers affirming Buffett's right to keep them ignorant. He literally cashed out one investor (involuntarily) who upbraided Buffett for his lack of disclosure. Several people interviewed for Buffett's biography declined to invest in his partnerships because they looked way too good to be true. Frankly in those early days Buffett's returns were better than Madoff's. Madoff learned from the best.

- The first chapter of Buffett's biography describes a speech he gave at a conference in 1999. The audience was filled with stinkin' rich people, including a number of tech & Internet gazillionaires who were riding high on the New Economy trend. Buffett's speech laid out comparisons to the 19th century railroad investors, the hundreds of car manufacturers that existed in the early 20th century, and what would have to happen to the global economy (let alone the U.S. economy) to keep the S&P500 & NASDAQ averages going. While it was clear that Buffett would never learn to blow PERL scripts, it was also pretty clear that the tech investment party was over. However in some quarters his speech was considered the equivalent of church flatulence.

 

[audreyh1]

Nords - I wasn't talking about the accredited "high-net-worth" investor. I was talking about the regular guy (i.e. retail investor) investing in mutual funds, ETFs and stocks. Doing away with the uptick rule, not going after naked shorters, allowing investment banks to take on ridiculous leverage, limiting enforcement of rules due to "limited staff" while at the same time not seeking adequate staffing to do the enforcing. These are the things that have made it appear to the retail investor that the deck is stacked against him and makes him reluctant to invest.

Whatever short term benefit Wall Street got with the above enforcement/rules change biases, they've blown it for themselves long term. Dis the retail investor, and the retail investor leaves the game. Oh they blew themselves up anyway I guess.

Hoisted by their own petard (that in fact means blown up by their own bomb)

Audrey

 

[Bestwifeever]

Today's Madoff story--hard to see how the little guy could protect him/herself from crooks when big institutions with presumably more analysts looking at where to put money cannot:

Alleged Madoff fraud hits Europe and Asia - Yahoo! News

 

[ERD50]

Today's Madoff story--hard to see how the little guy could protect him/herself from crooks when big institutions with presumably more analysts looking at where to put money cannot:

Alleged Madoff fraud hits Europe and Asia - Yahoo! News

Simple actually. Don't invest in what you don't understand. If it is so complex that you have to rely on 'analysts', it is too complex for us 'little guys'.

You would not have honestly invested with Madoff, would you (assuming you had the minimum amount to invest)? There is no way I would turn my money over to one guy, with that sort of lack of transparency.

I'm sure there is some fraud and problems among the 500 companies in the SPY ETF, but I have diversification on my side.

-ERD50

 

[SteveL]

From Fortune Mag on-line site: Madoff investors burned by SEC, too - Dec. 15, 2008

This has five suggestions for avoiding the Madoff kind of crime.

Still, avoiding fraud is difficult. Audits often don't find it. Even the best set of financial controls can be fooled, especially when supervisors don't review the things they are supposed to. You can't count on rating agencies, or regulators either.

About the only thing you can do is avoid more complex investments, widely diversify, and don't let some advisor have control over your decisions.

 

[saluki9]

I haven't sat for any Series XXX exams, but as far as I understand things, insider trades in any securities issued by a company (stock, bonds, preferred, derivatives, etc.) are reportable on form 4. I have seen insiders enter into total return swaps on an equity and the arrangement was reported on form 4, so I don't see why another OTC derivative (CDS) would not be reportable.

You are correct, all derivative trades are required to be disclosed on form 4.

In many cases corporations will have their own rules that are even more restrictive that the SEC on this issue. We have had many clients with letter stock who we tried unsuccessfully to collar because their employer had regulations against this.