Apparently, there were many red flags that might have tipped people off to Bernie Madoff’s fraud. Yet despite eight SEC investigations in the last sixteen years, he was not caught.
I wonder how many other large hedge funds or investment advisers have some of these:
A huge business audited by a tiny accounting firm.
The same firm acting as adviser, manager, custodian, and clearing agent.
No fees charged for managing money (only for trading).
Consistent 10%-20% returns every year.
Over 90% profitable quarters.
Large political donations. Note that while most big donors are not crooks, almost all big frauds are big donors: Enron, Worldcom, Fannie Mae, Madoff.
I haven’t seen hedge fund historical information online, but I wonder how many existing hedge funds have been profitable every year and almost every quarter.
Are any of these returns remarkably consistent as well? Inquiring minds want to know.
UPDATE: BTW, I do some of my trading through a Fidelity brokerage account, and I remember seeing that they did some of their trading of my orders through Madoff Investments, particularly, if I recall correctly, on after-market orders. A few months ago I got a couple of ridiculously bad fills on market-on-close orders (during normal trading hours) on some very heavily traded securities -- off by perhaps $1.75, when the bid-ask spread at close and immediately before close was 1 cent. I wonder whether these bad fills were Madoff ones (Fidelity's online records don't show this information for more than a day or so after the original trade report).
Fox: Another long night? This joint venture was your idea, and the consultants love it, but I'm not convinced. L.S.I.'s grown 8 percent annually, like clockwork. They must have a revenue stream that's off the books. Maybe even illegal.
Wayne: OK. Cancel the deal.
Fox: You already knew.
Wayne: I needed a closer look at their books.
1. A huge business audited by a tiny accounting firm.
a) Hedge funds aren't huge businesses operationally, even if they do manage a lot of money. More than a few managers run their funds out of office space in their homes in Greenwich.
b) Accordingly, it's not all that surprising to see that a hedge fund is not audited by one of the big accounting firms. Are you familiar with the Rothstein Kass & Co. accounting firm? I wasn't, until I learned that that firm is the #1 auditor for hedge funds.
2. The same firm acting as adviser, manager, custodian, and clearing agent.
Are adviser and manager two different things? (I'm asking, but I think generally the answer is no.)
3. No fees charged for managing money (only for trading).
In retrospect this fits into the puzzle, but given that hedge funds have been criticized for years for taking enormous and unwarranted fees, I understand why the SEC staff did not collectively rush to the Batmobile when alerted that a hedge fund was failing to charge its clients enormous fees.
6. Large political donations. Note that while most big donors are not crooks, almost all big frauds are big donors: Enron, Worldcom, Fannie Mae, Madoff.
I'm not sure it is quite true that Madoff was a big donor. Madoff may well have made donations bigger than you or I might make, but they aren't so large relative to other Wall Street contributors.
In particular, a mark of a big donor is that if your favored presidential candidate doesn't win the primary, you promptly make the maximum contribution to the party's actual nominee. I don't see that Madoff did that in 2004, and I don't see that he made any presidential contributions at all in 2008, although perhaps I'm missing something.
How many scams are being run inside of the banks that were bailed out? How much accounting fraud will not be uncovered because of newly-injected capital?
Market downturns expose fraud, since people watch their money more carefully in down times. Rather than allowing frauds to be exposed, the government is covering them up.
Evidently the people duped by Madoff figured he was timing the market. Essentially getting advance tipoffs of significant market moves by the big players and being able to put his moves in front of those.
Otherwise known as:
"front-running"
Possibly illegal which is why nobody really asked.
2) Rothstein Kass may not be one of the Big Four, but quoting its own site: "Rothstein Kass has grown to over 900 members in eight offices in New York, New Jersey, California, Colorado, Texas and the Cayman Islands." On the other hand, Friehling &Horowitz is a 3-person (reportedly only one of whom is an accountant), 1-office firm.
a) Yes, Madoff wasn't technically a hedge fund, but that regulatory distinction is irrelevant to my point. The point is that hedge funds, or investment managers, are operationally far smaller than (say) General Motors or Citigroup, and wouldn't require even close to a comparable amount of audit work.
b) I agree that Rothstein Kass isn't a tiny firm, and that the Friehling firm (if it was anything other than a sham) wasn't capable of performing an audit function. My point is that it is not surprising to see a hedge fund audited by an accounting firm you haven't heard of, and therefore that's not necessarily a red flag that would cause you to investigate.
5. Over 90% profitable quarters. [...]
I haven’t seen hedge fund historical information online, but I wonder how many existing hedge funds have been profitable every year and almost every quarter.
Are any of these returns remarkably consistent as well? Inquiring minds want to know.
Berkshire Hathaway -- Warren Buffett and Charlie Munger's company, ticker symbol BRK.A -- is arguably the closest thing there is to a publicly traded hedge fund.
Over the period 1991-2004 -- the same period reviewed by the 2005 Markopolos memo to the SEC on Madoff (see p. 19 of that memo) -- Berkshire's stock price increased in 39 of 56 quarters (about 70%), for an annual average of 19%.
Berkshire was considerably more volatile, however: it lost about 20% of its value in the last quarter of 1999.
Long story short is that Madoff's claimed returns for this period were at least plausible. The consistency might have seemed unusual -- and in retrospect we know that it was utterly fictional. Whether the SEC should be expected to have been alarmed by the consistency of the returns is another question.
Separate question. Why does a Hedge Fund - or any financial institution [not that HF's are FI's] feel the need to make political donations? Shouldn't that be a giant red flag by itself? Not saying their managers and officers can't personally contribute to whomever, but just why should entities be able to use fiduciary-sensitive funds for political purposes? THAT smacks of extremely brazen "investment" in my book.
Not entirely another question. The combination of high returns and low volatility should definitely raise alarms.
Nick
For investors, maybe -- but for the regulator? Do you take SEC staff off cases where people have actual losses to investigate whether some sophisticated and wealthy investors are too satisfied with their investment returns? (If $50b is at stake, maybe so, but I don't think it's an obvious call.)
Ask Bill Gates about that one. He thought he didn't need to make those contributions since he wasn't asking for political favors. If he had been making political contributions earlier, he might have had a much smaller target on his chest.
Hedge funds are an odd business and I suspect that politicians could randomly make life extremely difficult for any hedge fund manager. It is safer to make the contributions and buy a little protection.
Reasonable question. But maybe you pay close attention when you get a number of well-supported suggestions from credible people that the operation is a fraud.
I don't think Markopoulos was the only one raising concerns.
The hedgies did get bailed out by TALF on December 20th. I'm still waiting for my bailout.
Numerical tips to fraud are not always obvious (Rolls-Royces). See "Benford's Law".
I hear what you're saying, but the SEC can't quite be in the business of asserting that no investment advisor can beat the market and you might as well be in an index fund. Madoff claimed to be trading options based on a proprietary arbitrage strategy. If he really had such a strategy -- particularly a strategy that wasn't pegged to the broader movements of the stock market -- maybe it would generate stable returns. Who knows, we've only understood how to price options for 30-odd years, so perhaps Madoff came up with something new.
Of course, he actually didn't. He was just lying. But it would have odd for the SEC to presume that Madoff would have to be lying.
For what it's worth, finance blogger Paul Kedrosky ran the numbers and found that Madoff's claimed returns were roughly consistent with Benford's Law.
(For the uninitiated: Benford's Law is an observation about a recurring pattern in the distribution of digits in data sets. If the distribution of digits in a data set is not consistent with Benford's Law, that may be an indication that the data set is fraudulent. Of course, a sufficiently sophisticated sneak might make sure that his data don't violate Benford's Law. Alternatively, as Kedrosky speculates, the consistency of the return data with Benford's Law may just be an artifact of whatever method Madoff was using to generate the phony returns.)
Dang. Thanks for the link.
In addition to the investment (mis)management division (or hedge fun), Madoff's firm had a legitimate market-making division which was, at one point, the largest NASDAQ market maker as well as a major at the NYSE. Madoff's firm was the first to "pay for order flow", which is still a controversial point. In any case, you should examine the particular trades closely
2. The same firm acting as adviser, manager, custodian, and clearing agent.
Is this even legal?
That's not correct. The linked article says: "The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF)." In other words, hedge funds are being offered an incentive to invest in consumer loans. That may or may not be a good idea, but it's not a bailout. Hedge funds that have incurred losses are not being made whole.
This should have been the give away. Writing a check to BL Securities and not having an independent custodian of the assets is an invitation for fraud. If the assets are held by a 3rd party bank with deep pockets, it makes it harder for the assets/trades to go missing.
No mutual fund or pension fund invests this way ... the only industry that can be trusted with direct custody/control of client assets are lawyers! If only Madoff had been managing IOLA money!!!
As someone with experience in the industry (although I don't claim to be an expert), such a structure is to my knowledge legal. Indeed, such a structure may be desired depending on your goals. If you are hiring an personal advisor to manage money using a trading approach with numerous daily trades that are large and rapid-fire, you would almost certainly want this kind of structure, in order to allow the manager the ability to execute trades quickly and with secrecy (accepting the risk of theft); I believe that Fidelity, due to its size, has exactly this structure (although the differing functions are separated as different companies, all are under the Fidelity banner). If you've hired a personal manager to manage your money utilizing an investment strategy (longer-term time frame), such a structure would likely be unnecessary and would unquestionably put your money at risk of fraud.
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