How Bernie Madoff With the Money
Kurt Brouwer December 29th, 2008
My apologies for the play on words in the title. Just could not help myself.
By all accounts, the Madoff scandal was a fraud of epic proportions and a betrayal of those who entrusted their assets to him. If you have somehow missed out on the details of this $50 billion fraud, see Wall Street Journal — Madoff.
My reason for posting on this is quite simple. I have noticed a lack of clarity as to why — or more importantly — how it could have happened.
From what I have read, this investment fraud was made possible chiefly because investors with Madoff did not have an independent custodian for the assets entrusted to his firm. If there had been an independent custodian, I think the scheme would never have been possible. For example, it appears that Madoff did not make the trades in clients accounts that he claimed to have made. If those clients had an independent custodian, they would have seen their account holdings and transactions on the statement. If Madoff claimed to have made a given trade, but it never hit the client’s acount, a serious red flag would have been raised. Also, the returns he claimed were exaggerated. If clients were receiving accurate statements from the custodian, they would have known his performance claims were false.
Yes, investors could have dug deeper and questioned him further, but, in my opinion, the scheme was possible only because the Madoff firm was a brokerage firm that created its own client statements. In short, there was no independent verification that those reports were accurate. The Madoff scheme illustrates what can happen if you lack one of the very important checks and balances that are part of a sound investment structure.
Like many registered investment advisory firms, our firm, Brouwer & Janachowski, LLC, does not hold clients assets directly. Instead, clients have their assets in an account at an independent custodian that provides clients with statements showing the value of their assets, the number of positions held and so on. This type of independent verification of your account status is critical. We direct the investments in those accounts, but the positions held as well as the value of those investments are clearly shown in the statements from the custodian.
A second layer of protection exists for those who, like us, invest primarily in mutual funds because independent reporting on fund results is built by law into the mutual fund structure.
This piece from Brett Arends’ excellent ROI column in the Wall Street Journal makes the point that mutual funds are looking pretty good these days compared to the disaster experienced by the seemingly-sophisticated investors in the Madoff scheme. He lists 10 points from which I excerpted those I thought were most critical [emphasis added]:
Madoff: a Walking Ad for Mutual Funds (Wall Street Journal, December 16, 2020, Brett Arends)
A multibillion-dollar Ponzi scheme reinforces classic investment advice: If it sounds too good to be true, it probably is.
Bernard Madoff has done the impossible: He’s made the rest of Wall Street look good this year.
OK, so your funds lost 40% or more. Mr. Madoff’s clients, from charities to the super-rich, lost the whole salami.
Call it another reason to steer clear of so-called financial wizards and miracle investment funds. Here are 10 reasons why you’re better off opening an online account and investing in ordinary mutual funds - like anyone else.
1. You’ll always know where your money is, and you can get it out at any time…
2. You always know how you’re doing, too. Performance figures are updated daily…
4. Everything is out in the open. Mutual funds have to publish regular updates, telling you what they’ve been doing and why. Mr. Madoff actually kicked people out his fund if they asked too many questions…
Lucky people. Can you imagine how relieved you would be to have been one of those folks Madoff kicked out?
7. You can still get all the diversification you want. Though regular mutual funds you can invest in hedge-fund like “market neutral’ funds, managed timber, Asian real estate, precious metals, and option-selling income funds. You can keep your money in inflation-protected government bonds or Japanese yen. Exactly how much more diversification did you really need?
This is an important point that is often overlooked. Mutual funds cover a very broad array of investment opportunities, from stocks and bonds to gold, energy and many other asset classes.
9. And when you keep your money in public funds you won’t wake up one morning, switch on the news, and discover it’s all gone. The worst one-day loss in history for investors who entrusted their money to the U.S. public markets is about 20%. It happened just once, October 19, 2020 - and they got their money back in due course.
10. And if you really need to brag about your money at the country club, an $8 online trade and a $3,300 stake can get you one share in Berkshire Hathaway. Then you can smugly say, “I have my money with Warren Buffett.” Do you really believe your brother in law’s “financial whiz” is any better?
If you want to share in Buffett’s professional work, you can buy stock in his company, Berkshire Hathaway, which has some similarities to a closed-end mutual fund. Or, you can buy shares in mutual funds that own sizeable stakes in Berkshire Hathaway. The best-known of these funds is Sequoia Fund, which recently re-opened to investors (see Sequoia Fund To Open Up Again).
Obviously, most mutual funds have taken a hit this year. However, they have avoided scandals like the Madoff mess because of the checks and balances inherent to the mutual fund structure itself. This chart and text give you a sense of how funds work. It is excerpted from the Investment Company Factbook, which is created each year by the Investment Company Institute:
Source: Investment Company Institute
As you can see, mutual funds have an explicit structure with checks and balances including an independent audit by a public accounting firm. Investors in mutual funds typically focus on the fund’s portfolio manager and the types of returns the fund has gotten. It is only in times such as these that other aspects of the mutual fund structure come into focus. Those are illustrated in the chart above and in this text from the Factbook about the relatively unsung roles of the custodian and the transfer agent:
Custodians
Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Nearly all mutual funds use banks as their custodians. The SEC requires any bank acting as a mutual fund custodian to comply with various regulatory requirements designed to protect the fund’s assets, including provisions requiring the bank to segregate mutual fund portfolio securities from other bank assets.
Transfer Agents
Mutual funds and their shareholders also rely on the services of transfer agents to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments, including call centers, to respond to shareholder inquiries.
Here are several points I have made over the years. They illustrate precisely why mutual funds are so unique in the wild and woolly world of investing.
Mutual Funds Are A Unique Investment Vehicle
Mutual funds offer a package of advantages available nowhere else:
• Low minimum investment
• Immediate diversification
• Professional management
• Security
• Liquidity
• Audited track records
The first modern mutual fund was the Massachusetts Investors Trust, which came along in 1924, but it took years of trial and error, and a lot of misery before the mutual fund industry, as a whole, adopted the structure and safeguards we take for granted today.The shocking stock market crash of 1929 sparked the Great Depression of the 1930s-10 years of poverty, disillusionment and despair for many. Yet out of that disastrous decade came many reforms (such as the Securities Act of 1933, the Glass-Steagal Act of 1933 and the Fair Labor Standards Act) and the creation of many governmental oversight agencies (the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission, the National Labor Relations Board (NRLB), and the Federal Communications Commission, to name a few). For mutual fund investors, the watershed event was the passage by Congress of The Investment Company Act of 1940, which created the mutual fund structure as we know it today.
Mutual Funds & The Integrated Circuit?
By way of comparison, let’s travel back in time to California in 1959. In case you’ve forgotten, that was when Jack Kilby and Robert Noyce created the first integrated circuit, a single chip of silicon that replaced thousands of transistors and other electrical components and ushered in an era of unprecedented innovation as computer technology became cheaper and more powerful, year after year. From being the exclusive province of governments and well-funded university research laboratories, computer technology is now so pervasive and so inexpensive that we cannot imagine a world without it.
Just as the integrated circuit (the forebear to what we now call the semiconductor) brought computing power to people everywhere, the creation of the modern mutual fund structure changed the nature of financial services and opened up sophisticated investments to investors of all types. One piece of legislation created a new era for investors by setting up the safeguards and structure that enabled mutual funds to become the dominant investment vehicle they are today. This was a relatively simple innovation that did not receive much notice at the time. Yet, it opened up a myriad of possibilities and brought professional management, diversification, safety and other tangible benefits into the hands of all investors, no matter how much money or how little money they have.
Today, there are more mutual funds than stocks on the New York Stock Exchange. New funds open daily, offering a dazzling and sometimes intimidating array of choices. The competition for your money is so intense, that new innovations, marketing approaches, investment styles and services are being announced daily. The smartest people on Wall Street are eager and willing to work for you, for a nominal annual fee. In all of human history, there has never been a time like this.
The ’40 Investment Company Act — History’s Most Effective Regulation
So, we can thank the far-sighted legislators who created the modern mutual fund more than 60 years ago when they passed the Investment Company Act of 1940. That legislation has given us a golden era for investors that was previously unavailable to all but the very rich. And, as we have seen with the Madoff mess, even the rich would have been better off using mutual funds. Those who did avoided all these problems (Hedge Fund Troubles Take Tragic Turn).
But, even if you do not invest in mutual funds, there is an important safety feature that mutual funds pioneered — the independent custodian. If you invest in investment partnerships, hedge funds and other private investments, you can avoid the heartbreak now being felt by those who invested with Madoff — just make sure there is an independent custodian that holds your assets and reports to you as to the value of those assets.
If you take that simple step, you won’t ever have to wonder if someone is about to make off with your money.
Via: Rita Lee