What do the Royal Bank of Scotland, Nomura Holdings (Japan), the Elie Wiesel Foundation for Humanity, Yeshiva University, Tremont Group Holdings, Steven Spielberg's Wunderkinder Foundation and the owner of the New York Mets have in common? They are all victims of the (alleged) $50 billion Bernard Madoff scandal.
This loss is a tragedy of epic proportions. However, the real tragedy is that if investors had followed some basic rules of prudent investing, these investments would never have been made. Advisors offer their greatest value by helping their clients avoid such investing mistakes. This is especially true for those serving high-net-worth clients, who may be even more susceptible to schemes like Madoff's.
Many aspects of the Madoff affair are depressingly familiar:
? Trust in the promoter, often due to some social affiliation, encourages investment.
? The investment strategy lacks complete transparency.
? Returns seemed too good to be true, while there was a lack of audited financial statements.
? The affair unraveled at amazing speed.
There is nothing new in investing--only the history you don't know.
The exclusive nature of the hedge fund "club" creates an aura that seems to attract investors the way swim-up bars attract guests at all-inclusive resorts. They value the sensation of membership in an exclusive club. They yearn to be members of the "in crowd."
Consider some of the evidence put forward by an article in The Wall Street Journal that discussed some of the alleged middlemen, or "feeders," that funneled assets from social and business acquaintances into funds run by Madoff. One such person was described as a philanthropist who was well-connected to millionaires and billionaires in Florida. He purportedly recruited several investors to put their funds with his friend Madoff, who lived just two doors down. Another alleged feeder threw lavish parties at his home in Madrid for Spanish and Latin American high society--including heirs to some of Spain's largest banking and industrial fortunes. According to The Wall Street Journal, Spanish clients invested about $46.4 million into Madoff's funds. One observer said the host "managed to make this feel like an exclusive club people wanted desperately to be a part of."
The draw to be part of an exclusive investing club can be powerful. These kinds of connections can be difficult to overcome, but advisors must remember to work in their clients' best interests, even if that means explaining that joining this exclusive "club" may prove to be a poor choice down the road.
In addition to their "sex appeal," hedge funds lure investors with the ever-present hope of market-beating returns. But investors should have been aware that the very consistent returns Madoff reported were inconsistent with his particular strategy of buying puts and selling covered call options on stocks. During bear markets, the strategy should have resulted in losses--though less than that of the overall market. Yet Madoff was reporting consistent profits. That alone should have sounded an alarm. (In fact, some potential investors were scared off.)
There is an old saying about something being too good to be true. But if that's not convincing, consider that the number of trades required to execute the strategy would have far exceeded the number of trades reported on the entire exchange.
In addition to these problems, hedge funds have not only had a hard time keeping up with the risk-adjusted returns of riskless Treasury bills, but there is no evidence of any persistent performance beyond the randomly expected.
Perhaps it was the combination of such problems and the historical evidence on returns that led Prof. Eugene Fama, in an interview with (then Bloomberg) Wealth Manager in November 2002, to state with great prescience: "If you want to invest in something (hedge funds) where they steal your money and don't tell you what they're doing, be my guest."
Principles of Prudent Investing
At the very heart of our firm's investment philosophy is that our advice is based on scientific research, not our opinions. Strict adherence to that principle has served our clients well. We are just as proud of the investments we have helped our clients avoid as we are of the ones we have recommended.
We focus on the only thing we can control: risk. We do that by designing portfolios that provide our clients with the greatest chance of achieving their financial goals without enduring more risk than they have the ability, willingness or need to take.
Scientific research also led us to conclude that the prudent strategy was to capture the returns markets provide. We recognized that while this basically meant giving up the hope of outperforming the market, it also meant avoiding the risk of underperforming--the far greater likelihood. Therefore, the only equity funds we recommend are those that are low-cost, tax-efficient, passively managed asset class funds such as those of Dimensional Fund Advisors (DFA). And our fixed income strategy is based on the same principle of earning market returns.
"Pay no attention to the man behind the curtain"
Madoff was able to execute his massive fraud because he operated behind "a curtain." On the other hand, among the advantages of publicly traded mutual funds is a high degree of transparency. Other advantages are:
? Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission. Hedge funds are basically unregulated.
? Mutual funds must have audited financial statements. (DFA uses the major accounting firm, PricewaterhouseCoopers.)
? Mutual funds do not act as custodian of the assets. Our clients' funds are custodied mainly with Schwab or Fidelity.
? Mutual funds do not perform their own accounting. In the case of DFA, fund accounting is performed by PNC Bank.
In addition, another important consideration is that there is no incentive for DFA to take risks to try to outperform. (Such efforts often lead down the path to perdition as fund managers seek to recoup losses.) DFA does not attract assets the way hedge funds do by weaving stories about how they can beat the market or earn market rates of return while taking less risk. Their goal is simply to earn market rates of return. Unlike hedge funds, they don't offer incentive fees to tempt managers to take risks. And historical evidence demonstrates that returns earned by DFA's funds are consistent with their stated strategy. There are no episodes of either dramatic outperformance or underperformance beyond the randomly expected.
Summary
Among those who experienced the greatest losses from the fraud perpetrated by Madoff are some of the country's largest banks and hedge funds. They touted their ability to identify money managers who would deliver market-beating returns on a risk-adjusted basis. They proudly discussed their superior due diligence efforts to protect investors. As the academic evidence has demonstrated, their claims were without merit.
The saddest part of this great tragedy is that if investors had known the historical evidence and followed the basic rules of prudent investing, this tragedy would have been avoided.
Larry E. Swedroe (bamservices@bamstl.com) is a principal and the director of research for the Buckingham Family of Financial Services and author of seven books, including The Only Guide to Alternative Investments You'll Ever Need.
