Why fund selectors must watch Netflix’s “MADOFF: The Monster of Wall Street”

One of the benefits of doing Dry January is having more time on your hands, and this year I ploughed through the new Netflix documentary about the Bernie Madoff scandal, “MADOFF: The Monster of Wall Street”.

It might not be the Bourne Identity but it’s still an engrossing, fast-paced watch – and even if you were around as the scandal broke in late 2008 (like I was), there is plenty of new stuff in there.

As for the plot, you could not make it up: penny trade broker to hedge fund manager with the Midas touch – or so everyone thought until it all came crashing down around Wall Street’s ‘financial serial killer’.

The Bernie Madoff scandal is one of the biggest financial frauds in history, a massive Ponzi scheme which lasted for decades, involved billions of dollars and devastated the lives of his clients.

As a fund selector, I could not help thinking about the professional investors who put client money into his fund at the time.

In hindsight, it seems obvious that the fund’s performance was too good to be true, but investors wanted to tap into his magic, and in many cases fell foul to the behavioural biases that can cloud critical thinking and judgement.

At the time, I was covering long-only equity funds, so Madoff did not come across my radar, but if a re-run of the Madoff Scandal happened now, would fund selectors make the same mistakes?

There are a number of lessons that can help investment teams navigate risk associated with fund research and protect their clients’ investments:

Lesson 1: There’s no substitute for due diligence

It can be boring and time-consuming, but it has to be done and cannot be rushed.

What is the philosophy, process, risk management etc – and how can it be evidenced in the portfolio and return stream?

In the case of Madoff, many investors failed to do proper (if any) due diligence and simply trusted his reputation without verifying his investment returns. Buyer beware!

Lesson 2: Red flags should not be ignored

Red flags, such as consistent returns regardless of market conditions, the secrecy around the process and operations, the valuations printed out on dot matrix paper, the SEC investigations, the press articles insinuating something wasn’t right… all were big warning signs that needed to be taken into account.

Any one of them should have been enough to raise concerns; a few together should have had the alarm bells ringing.

Lesson 3: On-Site visits are crucial

What was interesting in the documentary was the stark contrast between the office set-up of Madoff’s legitimate securities business and the HQ of the Ponzi scheme a few floors below: one pristine, the other a complete mess.

Going on-site to meet PMs, analysts, traders, C-suite and other key staff is crucial to truly understanding the operations and culture of a firm.

Clearly, Madoff would not have shown anyone the Ponzi floor, but this would have told you everything (if you would cared to take a look).

Lesson 4: Comparing returns to peer group is essential

No fund manager has come up with a process so unique that their returns behave entirely differently from anything else.

Some funds are clearly superior to others, but typically they are part of a peer group whose participants at least have a passing resemblance to each other.

With Madoff, there were no other funds that could match the consistency of returns that he purported to have produced.

Analysing funds in the context of peers helps highlight an outlier such as this. And if someone is doing something truly different to everyone else, it’s worth a much closer look.

So, what is the ‘So What?’ The Madoff scandal serves as a cautionary tale for fund selectors.

Whenever we think we are all done with financial scandals, another normally emerges to join the illustrious line-up of Allen Stanford, Bernie Madoff and Jho Low (the billion-dollar whale).

But by following the framework of rigorous due diligence, on-site visits, peer group comparison, and being aware of red flags, fund selectors can reduce the risk of similar scams and help ensure the safety of their clients’ assets.