Lessons from the Madoff Scandal, part two

The discussion of the Ponzi scheme perpetrated by Bernard Madoff is likely to continue for a long time, and it raises several issues that are worth discussing, including many important issues concerning regulation and the SEC.

However, there are at least two issues that the Madoff scandal exposes that are absolutely vital for all investors to understand, whether you are investing millions (or even billions) of dollars, or whether you are investing sums less than those lost by Madoff.

1. The intermediary trap.

It has been noted that most of those who lost money with Bernard Madoff did not invest directly with him, but did so through an intermediary. Some of those that he robbed of their savings were his personal friends, including people he had known for decades, but even more were robbed because they gave their money to "middlemen" who charged a fee themselves, and then farmed the management out to other managers -- in this case, to Bernard Madoff.

Over the weekend, the Wall Street Journal published the story "Madoff Feeders under Focus," (follow the link and then click the title of the story at the Digg website) which shows that some of these "middlemen" charged significant fees, even though they were not actually managing the money themselves but were only funneling the money to other managers. One apparently charged a "1 and 20," meaning 1% per year and 20% of any upside, while another charged an exorbitant 4.5% per year. These fees were for the middlemen; Madoff himself apparently made money by brokerage commissions on the trades he made (as well as by siphoning money from clients, which will now apparently result in a cost of 100% to most or all of them).

This arrangement, of paying a middleman who does not actually manage the money but rather farms it out to someone else, is actually a very common arrangement in the financial services industry -- in fact, it is the arrangement that the entire industry is built on. We have explained extensively why we believe it is a bad arrangement in previous posts, including "The Intermediary Trap" back in February of 2008. The diagram above, from that post, shows the "middlemen" in circle "B" -- they are often called "financial advisors" or "wealth managers."

To be sure, most middlemen do not farm the money out to managers who turn out to be fraudulent criminals. The reason this setup usually leads to substandard returns -- and extensive data over many years supports this assertion -- is not that the manager (or the middleman) are in any way nefarious, but rather that the manager's long-term returns ("point C") end up being better than what the original investor ("point A") experiences, because along the way the middleman ("point B") decides to do "something better" and short-circuits the manager.

However, the reason that the middleman tends to short-circuit the process is that the middleman is very focused on one-year performance numbers. When he sits down with his clients, he is very aware of "how manager X did in 2008, how manager Y did in 2008," and so on. This short-term focus (short-term compared to the business prospects of a well-run growing company, which can take a few years or more to realize its full business potential) is what leads investors -- and their advisors -- astray, according to studies on the matter.

This focus on the one-year performance numbers is a common trait of middlemen, and it certainly was a factor in the Bernard Madoff scandal, in which middlemen and their investors were clearly attracted by what they thought were consistently good one-year performance numbers.

The fact that the middlemen in the Madoff scandal did not believe he was actually stealing investors' money is fairly clear from the fact that many of them invested their own funds in his program as well. This is related to the discussion of "eating one's own cooking" which we have examined previously.

In this context, however, it highlights the extent to which these middlemen were unable to actually understand the investment management they were putting their clients into, which is another problem with the intermediary trap even when fraud is not involved.

The entire premise of the intermediary structure is that the intermediary doesn't get "bogged down" in the demanding job of actually making calls on individual securities in the portfolio -- let the manager do that. This supposedly frees up the middleman to be better at "wealth management" and the evaluation of managers.

We have always questioned that premise, and wondered why anyone would want to have someone giving them advice about investment management who is not actually in the trenches themselves and does not know how to be. We discussed this issue over a year ago in a post entitled "Don't hire a journalist to coach your team." The Madoff scandal demonstrates very clearly that even the most apparently successful and sophisticated middlemen in the world are still just middlemen. Better to have your investment manager be the one who actually understands the strategy on which your life savings depends.

This lack of transparency brings us to the second critical lesson that the Madoff scandal illustrates:

2. The zero-sum connection.

Madoff's apparently world-class returns were billed as the product of a sophisticated trading strategy, one that could exploit market inefficiencies. The Wall Street Journal story cited above contains an investor presentation claiming that the strategy involved something called an "approximate notional put hedge," among other things (just how "notional" it would turn out to be no doubt came as a surprise to everybody).

Several news articles since the scandal surfaced, such as this one, note that many sources report that "if current clients asked Madoff too many questions about how he invested, he kicked them out."

"Secret" trading strategies that must remain secret in order to work should raise a red flag.

Many in the general public have been led to believe that investing is all about finding out some secret information before everyone else and then profiting from it. However, that is only one type of investment strategy, and one that is antithetical to the investment philosophy practiced at Taylor Frigon Capital Management.

It is true that arbitrage strategies and many of the strategies followed by hedge funds are based on secret (or, more commonly, "proprietary") methods of exploiting inefficiencies, such an approach is necessarily a zero-sum game. One side of the trade benefits at the expense of the other side in such a strategy.

On the contrary, we advocate a strategy that is based upon the ownership of well-run businesses that are positioned in front of major growth opportunities. Such a strategy is not dependent upon keeping a secret or moving at lightning speeds -- instead, it is dependent upon having the discipline to do the homework to identify those companies, and then having the discipline to stay with them through the various cycles that come along on their way to realizing their business potential.

This is almost the exact opposite of secret or proprietary trading strategies -- an investor in such a strategy may even find himself in the position of telling others how good a company's prospects are, but people will not want to listen because the cycles are against that company at that particular time. In other words, he doesn't need to keep it a secret the way someone running a zero-sum strategy does.

That's because the classic growth strategy is a positive-sum game -- it is based upon the principle that enterprising companies can and do actually add new value that was not there before. Such a strategy aims to allow investors to participate in such new value creation, and thus it is the opposite of the zero-sum approach which many mistakenly believe is the heart of what it means to be an investor.

We have discussed the difference between zero-sum trading strategies and the classic growth investment philosophy in the past as well, such as in this post from June of 2008.

The Bernard Madoff scandal is a despicable episode and one that has apparently resulted in the robbery of billions of dollars of wealth from hundreds of families, foundations, and institutions. Investors should carefully consider the two important issues that it exposes in a dramatic object lesson.

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For later posts on this same subject, see also: