A Tragic Case of Misplaced Trust

As I continue to read about Bernard L. Madoff who was arrested and charged with securities fraud that could involve losses of more than $50 billion, one word keeps coming to mind—unbelievable.  It’s unbelievable that one man in whom so many people put their trust would allegedly violate that trust. It’s unbelievable that so many investors—from individuals to hedge funds and charitable foundations—never questioned returns that at some level they must have know were too good to be true. It’s unbelievable that the Ponzi scheme that allegedly operated for more than a decade was undetected by the Securities and Exchange Commission.

As Madoff’s investors search for answers, one first-hand account written by veteran personal finance journalist Robert Powell stands out. Last year, Powell reports that he tried to learn more about Bernard L. Madoff Investment Securities LLC after reviewing the impressive performance of his wife’s 401(k) for 2007 (Madoff managed the 401(k) plan of his wife’s employer). However, he found little information about the firm on its web site. And searches on the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) web sites also turned up very little. Yet, Powell failed to dig deeper.

For the nine months ending September 2008 his wife’s account was up 6%. But rather than pursue his initial questions, Powell reports he and his wife believed they could be investing with the “next Bill Miller or Peter Lynch.” In fact, they discussed increasing her 401(k) contribution. Misplaced trust and satisfaction with market-beating performance clouded their judgment.

With Madoff’s long list of victims including Steven Spielberg, Mort Zuckerman, and high profile institutional investors like the Fairfield Greenwich Group that lost a reported $7.5 billion, the question becomes: If high-powered attorneys, private bankers, and savvy investment managers couldn’t protect their clients from Madoff, what protection does anyone have? Ironically, what could be the biggest investment scam in U.S. history unfolded because investors forget the most basic rules of investing.

  • Use an independent custodian. While we manage our clients’ accounts at TD Ameritrade using a limited power of attorney, Madoff’s firm acted as the investment manager and the brokerage custodian that processed securities transactions and issued dividends and interest. There were no checks and balances. Accordingly, when Madoff the investment manager stole from the accounts, Madoff the custodian covered his tracks. Your assets always should be held with an independent custodian like TD Ameritrade.
  • Work with an independent Registered Investment Advisor. For the most part, registered investment advisors who manage $25 million or more in client assets must register with the SEC. If they manage less than $25 million, they must register with the state securities agency in the state where they have their principal place of business. Hedge funds—a private investment fund open to a limited range of investors—may not be registered with any government regulators. Ironically, the traditional thinking was that hedge funds’ high net-worth investors would be experienced enough not to need standard government protection. However, the Madoff case has disproved that assumption and perhaps paved the way for the secrecy of hedge funds and hedge funds of funds to be legislated away.
  • Don’t put all your eggs in one basket. Wowed by consistent market beating performance, many of Madoff’s investors forgot that wealth is most quickly lost by concentrating on only one or a few investments.Spreading money between stocks, bonds, and cash (asset classes that historically have responded differently to market conditions) as well as between various investment styles tempers portfolio risk. We achieve this diversification most effectively through the ownership of DFA mutual funds rather than individual stocks. Because a mutual fund often represents ownership in hundreds or thousands of companies in different industries, a mutual fund further diversifies your portfolio.
  • Understand what you invest in.When we invest in the highly transparent mutual fund marketplace, we know what we own. The same cannot be said of “black box” hedge funds that remain cloaked in secrecy. We always want to see how your funds are invested so we can verify that they are indeed secure. What’s more, the direct line of communication we enjoy with all DFA fund managers enables us to gain valuable insight into their investment decisions and market outlook. As for other investment offers you may encounter, remember that legitimate firms leave a long, easily accessible data trail. If you cannot locate sufficient information, don’t invest. Of course, we’re always happy to assist you with your research.
  • Question the impossible. When an investment manager claims to have investment results that are far better than all his or her peers and consistently beats the overall market, be skeptical. One of Mr. Madoff’s more prominent funds, the Fairfield Sentry fund, reported having $7.3 billion in assets in October 2008 and claimed to have paid more than 11 percent interest each year through its 15-year track record ing to a New York Times article. When evaluating potential investments, remember the old adage: “If it sounds too good to be true, it probably is.”

The tragedy of the Madoff affair is that thousands of people put their trust in someone who didn’t deserve that trust. The collateral damage caused by that misplaced trust is not yet fully known for these individuals and institutions. For the rest of us, however, the story reverberates as another piece of bad news in what will go down as one of the worst investment years in history.

There’s no question the global economy is as difficult as we have seen in our lifetimes, but I’m confident the markets will recover from this recession. In the months ahead, I encourage you to try to block out some of the negative market noise and concentrate on what’s right in your life. As I look ahead to 2009, I’m grateful for the many client relationships we enjoy. We value our clients’ trust and remain committed to providing the extra support you may need to tolerate the market’s recent swings, and we remain committed to your financial plan in order to reach your goals.

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