What Lessons Can Investors Learn From Bernie Madoff?

Will the last person on Wall Street with a shred of integrity please turn off the lights on your way out?

Wall Street's list of transgressions against individual investors is long and sordid, and it has reached its epiphany in 2008. Brokerage firms marooned thousands of investors with billions of dollars in short-term liquidity needs in auction rate securities when they stopped supporting the auctions. (But not before they got their own money out.) Investment banks wiped out legions of their own shareholders and very nearly collapsed the global financial system when they got hooked on their own junk and larded up their balance sheets with highly leveraged bets on mortgage derivatives. (But not before they paid out nine-figure bonuses to their executives.)

Now we learn that one of the supposed pillars of the Wall Street trading community - Bernard Madoff, the former head of Nasdaq - has, by his own admission, been running a $50 billion Ponzi scheme disguised as an investment firm. According to The Wall Street Journal, it may be the largest financial fraud in history.

Our financial system is built on trust and confidence. As we have amply seen in the past three months, when that trust is violated, the public's confidence washes out like the ocean tides and it can be a long while before it rolls back in. In the interim the health of our entire economy is jeopardized.

Given the scope of the violations of investor good faith that have occurred this year, it may well lead one to wonder if anyone can be trusted to manage money anymore. While there are no guarantees about any individual manager's capabilities or trustworthiness, there are four key concepts that investors can embrace that will greatly reduce their risk of ending up the next Wall Street victim:

1. There's no such thing as a free lunch: Wall Street loves to perpetuate the myth that there is some way around the relationship between risk and reward. There's not. If you are attaining world-beating returns, rest assured you are taking on an amount of risk commensurate with those returns. You may get away with it for awhile, as investors in dot.com stocks did in 1998 and 1999, but sooner or later the heavy hand of the market will come knocking on your door and collect on the risk you assumed. It doesn't matter if you have a $2,000 IRA or a $2 billion foundation - there is no such thing as a free lunch in the capital markets (just ask Lehman Brothers).

Ironically, it is wealthy investors who often fall prey to this belief, because they have an endless string of Wall Street hucksters whispering in their ear that, thanks to their financial largesse, they have access to "special opportunities" not available to the unwashed masses. Wealthy investors flocked to Mr. Madoff - who billed himself as the advisor to the super-rich and famous - because of his uncanny ability to produce an investment return of between 8% and 10%, year after year, regardless of the market environment. He was idolized by his who's-who of clients as someone who had magically figured out a way around all that messy volatility that is normally associated with the stock market. But as his investors learned the hard way, it wasn't magic at all. It was fraud.

2. Don't fall for the siren song of the "star manager": There will always be periods of time when a handful of money managers dramatically outpace the broad market, some of them for extended periods of time. But how can you really know if they were good, or just lucky? The answer is you can't. A 1993 study by SEI Corp. determined that a manager's track record would have to be ninety years long before you could know with certainty that his outsized returns were attributable to luck as opposed to skill. And a more recent study found that the percentage of managers who had bested the market by such a convincing amount that it could only be attributed to skill was 0.6% -- essentially zero!

Most investors can't resist the temptation to go with the latest, greatest money manager and often arrive at the party too late, after the outsized returns have already been generated, just in time for the fund to come crashing back to earth. Just look at all those investors who piled into the Legg Mason Value Trust Fund in recent years. Run by the once-revered Bill Miller, the fund beat the S&P 500 for 15 consecutive years. Alas, in 2008 the fund lost more than 60% of its value, wiping out the entire decade-and-a-half's worth of market-beating returns in a single year.

3. Third-party custodians are your friend: Brokers work for brokerage firms, which means your assets are held at the same place your broker works. While most individual brokers are honest people, this set up makes it far easier for the few bad apples to perpetrate the kinds of frauds we have seen proliferate in the brokerage industry in recent years - punctuated on an epic scale in the Madoff case.

In contrast, fee-only advisors who use independent custodians such as Schwab, Fidelity and TD Ameritrade provide investors with an important additional level of asset protection. In such a set up, the advisor has discretion to manage the account on behalf of the client, but has no access to the money. Accounts are set up in the client's name, and the custodian will only send distributions from the account to the client's address of record, not to the advisor. Likewise, account statements are sent directly from the custodian to the client, which means there is no way for an advisor to stop the flow of statements and trade confirmations to the client (which is how most frauds get perpetrated). Finally, if a client becomes dissatisfied and wants to move his account, he can walk into any Fidelity or Schwab branch office and do so without ever having to talk to the advisor - something that brokerage firms make notoriously difficult for their investors.

4. Mutual funds aren't "unsophisticated": Mutual funds are often portrayed by Wall Street salesmen as the unsophisticated tools of small investors. "We can do better than that," they say. "We have access to the country's most exclusive private money managers!" It sounds great in theory, but these "separately managed accounts" (SMAs) rarely outperform a well-constructed portfolio of open-end mutual funds, thanks to the high fees and excessive trading activity of most SMA programs.

Of greater concern is the lack of transparency associated with SMA programs. Last year our firm was asked to audit the investments in the 401(k) plan of a professional services firm in Atlanta. We were unable to do so, however, because the plan was at a brokerage firm that was using private money managers in a Unit Investment Trust structure, as opposed to publicly traded mutual funds. None of the investments could be evaluated via a third-party database such as Morningstar or Value Line. In fact, all of the information about these investments - what little there was - was being provided by the brokerage firm and the money managers themselves. It is just this type of fox-and-henhouse arrangement that allowed Madoff to perpetrate his fraud, a significant portion of which was inflicted on 401(k) plan participants whose companies invested in Madoff's fund.

In contrast, open-end mutual funds are governed by the strict reporting requirements of the Investment Company Act of 1940. Information about the country's 8,000-plus mutual funds is readily available through literally hundreds of different sources, and it is easy for investors and their advisors to understand what the fund is investing in and how its strategy has performed. With a portfolio of a dozen or so low-fee, low-turnover mutual funds (such as index funds), an investor can gain access to thousands of securities all over the world.

As we have amply seen in the past few months, sometimes there is no place to hide for stock investors; there is risk in the equity markets and in times of turmoil it cannot be avoided. But most investors greatly compound their problems by taking on unnecessary and imprudent risk: The risk of being concentrated in just a few stocks or market sectors. The risk of being exposed to the mistaken bets of a particularly money manager. And, in the Madoff case, the massive risk of entrusting the wrong person with the keys to their entire financial castle and no checks-and-balances.

These are easy risks to avoid, and we need look no further than Bernie Madoff's client list to see what the repercussions can be when investors fail to do so.