Wednesday, December 17, 2008

WHAT THE MADOFF PONZI SCHEME IS TEACHING EVERY INVESTOR

How did we and many others resist the attraction of a seeming sure thing in the Madoff Ponzi scheme? Many noticed that Madoff's proposal had a few red flags. They were:

1. Madoff's investment advisory business used his own firm as the custodian for all managed client's assets. In general, investors should not invest with an investment manager who is also the custodian of the assets. Having a separate, unaffiliated custodial firms' administrative and compliance policies and procedures helps safeguard against fraud, and makes it easier to confirm that the assets are actually there.

2. Madoff refused to give investors any insight whatsoever into his method of investing. It has been reported that some investors were given their money back for being too nosy. Never invest with a manager who refuses to give you the details of how the money is being managed. If the style of management is too secret to share, then it is probably too secret to work for a prolonged period of time. Supposed secret ways of managing money have a way of getting out. Once the secret is out, a large number of imitators will decrease the perceived exclusivity of the technique. Apparently, with Madoff, the "secret" could be maintained because the assets of investors were not circulated through outside traders and other institutions, but were kept in-house, and either sent to the earlier investors or kept by Madoff.

3. Madoff's record of low volatility appreciation was impossible for others to duplicate. No scientific experiment is considered valid if it cannot be duplicated. How was Madoff able to get stable returns irrespective of market volatility? Sure, investments can be hedged, but hedges also are affected by changes in market volatility. When equity market volatility changes (as it has tremendously in the past year), some degree of volatility change should be reflected in the performance of any equity investment vehicle.

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