Lessons from Madoff and his Ponzi scheme

With last week's announcement of the largest Ponzi scheme of all time it is important for investors to understand that for a Ponzi scheme to work, the operator has to take the money from one investor and give it out to another.

In order to do that, the first investor must lose visibility of his money. In other words, he must be unable to see what is actually happening in his account, either because he does not get regular account statements every month, or because he gets false account statements every month.

In the case of the Madoff fraud, the investors were receiving false account statements every month. For this to happen, the custodian of the assets (where the accounts are held) must be part of the scheme. In the Madoff fraud, Madoff's own broker/dealer firm was acting as the custodian for his clients.

The Wall Street Journal today published an article explaining ways investors can avoid falling into such a situation. Most important of the recommendations is the sentence "If your adviser manages your investments, but the funds are actually held at, say, Charles Schwab or Fidelity, it's almost impossible for him or her to run a Ponzi scheme." That is because it is extremely unlikely that a separate custodian firm, especially a large and well-known firm, would enter into an agreement to commit fraud, or that such a firm would be able to hide such a fraud.

Ultimately, we believe that it is wise for clients to get their investment advice from a source that is separate from the custodian who holds their assets and trades their accounts.

In fact, the larger general lesson that investors may draw from this scandal is that the advisory business, including asset management, should be separate from the brokerage/custodial business -- and the investment banking business as well. We have made a similar point in the past, such as in this post.

Investors whose assets are currently held with a large reputable custodian who is separate from their investment advisor are much less vulnerable to the kind of fraud perpetrated by Bernie Madoff.

For later blog posts dealing with this same subject, see also:

• "Lessons from the Madoff Scandal, part two" 12/29/2008.

• "The same thought process for 30+ years" 03/31/2009.

• "The best defense is a good offense!" 12/03/2009.

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