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Reproduced with the kind permission of Dimensional Fund Advisors (United States) A long list of wealthy investors both in the US and abroad have been shocked to learn that Bernard L. Madoff, a prominent and well-respected broker and money manager, has been accused of orchestrating one of the most extensive investment frauds in US history. Madoff’s New York broker-dealer firm, Bernard L. Madoff Investment Securities, had earned a solid reputation since its founding in 1960 and specialized in executing trades for other broker-dealers, banks, and financial institutions. Madoff is a former chairman of the Nasdaq Stock Market, and his firm is one of the most prominent market-makers of Nasdaq-listed securities. A separate investment advisory division managed money for wealthy individuals, although the firm generally charged no management fee and earned compensation through its broker-dealer arm from trading commissions. A complaint filed by the Securities and Exchange Commission last week asserts that Madoff “admitted to one or more employees of BMIS that for many years he has been conducting a Ponzi scheme through the investment adviser activities of BMIS and that BMIS has liabilities of approximately $50 billion.” [Charles Ponzi, an impoverished immigrant with an entrepreneurial bent and a gift for persuasion, attracted millions to his Boston-based firm by promising investors a 50% return in just 45 days, allegedly by profiting from an arbitrage opportunity associated with international postal reply coupons. He attracted a legion of loyal followers in the summer of 1920, but the firm unraveled quickly when state regulators and financial journalists began to probe his affairs, and he pled guilty in November 1920. He served two prison terms and died a pauper in a charity hospital in Rio de Janeiro in 1949.] Madoff developed an enthusiastic following by delivering steady returns in both good and bad markets over many years. According to a skeptical Barron’s article appearing in 2001, a hedge fund managed by Madoff had experienced only four negative months since its inception in 1989. The source of such pleasing results was reputedly a “split-strike conversion” strategy involving the purchase of large cap stocks such as GE or Coca-Cola while limiting the downside through purchase of put options and generating income through the sale of covered call options. By limiting both the upside and the downside, the strategy was able to deliver steady if unspectacular returns that were especially appealing to income-oriented investors. Barron’s wondered, however, why other sophisticated investors seemed unable to duplicate such results and noted that options experts at other firms were skeptical of the claimed results. “Anybody who’s a seasoned hedge-fund investor knows the split-strike conversion is not the whole story,” one professional explained. “To take it at face value is a bit naive.” The list of wealthy investors who stand to lose substantial sums includes prominent business executives, sports team owners, celebrities, high-profile lawyers, university endowments, and numerous members of the Palm Beach Country Club, where Madoff’s alleged investment prowess was a popular topic of conversation. Some clients invested much of their net worth with Madoff, and the financial distress is likely to be severe. One high-end pawnbroker in West Palm Beach reported an upsurge of calls over the weekend and fielded inquiries regarding loans collateralized by a yacht, a Ferrari, and a Tiffany ring. According to press reports, a number of international banks have exposure as well, including HSBC and Royal Bank of Scotland (UK), BNP Paribas (France), Banco Santander (Spain), and Neue Private Bank (Switzerland). Those who redeemed their money before the collapse may discover they have little cause to celebrate. A federal bankruptcy court recently determined that investors who had redeemed their money prior to the Bayou Group hedge fund collapse in 2005 were obligated to return a portion of their original contribution as well as all of their profits. One client who had pulled money out nearly two years before the end was stunned to discover he was still liable. Many aspects of the Madoff affair are depressingly familiar: the lure of high returns with little risk, glowing testimonials from early investors, the sense of membership in a special club for those fortunate enough to be “in the know,” the trust in the promoter due to religious or social affiliation, the vague documentation of investment strategy, the skimpy accounting, and the speed of the ultimate collapse. One of the puzzles that investors and regulators will grapple with is Madoff’s ability to earn and maintain the trust of organizations whose primary business is conducting extensive due diligence on money managers. One fund-of-funds firm that had directed large sums to Madoff was founded by a former Securities and Exchange Commission official, and took pride in its rigorous approach, describing its due diligence process as “deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment . . . Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the platform.” Many of Madoff’s investors dismissed concerns about the difficulty of identifying the source of the impressive results. One satisfied investor told Barron’s “Even knowledgeable people can’t really tell you what he’s doing.” This unfortunate tale offers a bitter lesson to investors: steady returns and recommendations from friends and trusted advisors are no substitute for clarity and transparency. References: Arvedlund, Erin E. “Don’t Ask, Don’t Tell.” Barron’s, May 7, 2001. Fairfield Greenwich Group. Fggus.com, accessed December 12, 2008. Henriques, Diana B., and Alex Berenson. “Fraud Inquiry Centers on Investment Firm’s Sanctum.” New York Times, December 15, 2008. Kim, Jane J., and Jenny Strasburg. “Investors May Have to Surrender Gains.” Wall Street Journal, December 15, 2008. Lattman, Peter, and Aaron Lucchetti. “Losses in Madoff Case Spread.” Wall Street Journal, December 15, 2008. Prada, Paulo. “In Palm Beach, Investors Assume Worst.” Palm Beach Post, December 15, 2008. Securities and Exchange Commission. Press release, in www.sec.gov, accessed December 12, 2008.