Lessons From the Madoff Scandal

by Michael Nachbar | Let's not throw away any more money.

Tufts’ endowment managers have recently been reminded all too clearly of that old saying about something too good to be true. Like many other investors lured by the gaudy returns posted by affiliates of Bernie Madoff’s Ponzi scheme, Tufts gave $20 million to Ascot Partners in 2005, all of which was lost when the scheme collapsed in late 2008. The blow is an embarrassment to Tufts, but not nearly as critical as the losses suffered by Yeshiva University, which lost 10 percent of its endowment, or charities such as The Elie Wiesel Foundation for Humanity, which lost all of its money in the scheme. Still, Tufts has gone as far as admitting it made serious errors in its investing, and losing an extra $20 million in the midst of a financial crisis will only further hinder goals such as need-blind admissions and renovating athletic facilities. Here are five lessons that must be learned by Tufts and investors across the world.

1. Do not rely on government regulators: Critics will correctly blame the SEC for failing to do its job in investigating Madoff’s obviously questionable returns. Their mistake is futilely hoping for a competent governing body. Because the potential profit in Wall Street fraud so heavily outweighs the SEC’s funding, firms will invariably manage to manipulate the SEC’s corruption and incompetence. For the same reason the drug trade and illegal immigrant industry can never seem to be properly policed, Wall Street fraud will always exist. Just as Moody’s and Standard and Poor’s cannot be counted on to assess the stability of bonds, the SEC cannot be relied on to verify funds. Expect inspection of hedge funds and securities to become a thriving industry, and one of which Tufts should become a client.

2. The past two decades were the exception, not the rule: Madoff’s victims all trusted him because he had posted strong returns over a long period. That period, however, consisted of the 90s and 00s, in which the markets flourished consistently. Too many investors mistook this anomaly for the new norm, and placed money in funds such as Madoff’s that had never withstood a serious economic downturn. During a twenty-year period in which every market and every sector saw gains, plenty of poor investment strategies turned profits anyway. Foolish were those who mistook them for prudent.

3. Returns must be justified with sensible strategy: Madoff’s stated strategy was relatively simple. He bought blue chip stocks and indexes and hedged them with options that paid back if the stock fell or rose drastically. This strategy has never been proven successful, and many analysts attempted calculations to justify his tremendous earnings and could not come close.  One analyst, Harry Markopolos, sent a report to the SEC stating that Madoff’s fund should theoretically not outperform treasuries. Markopolos also proved that for the fund to perform as stated to the public, it would have needed to purchase more of a certain type of option than existed in the entire world. Before investors commit money to a fund, they must ensure that its strategy makes some intuitive sense and holds up under scrutiny.

4. “Everyone else is doing it” is no excuse: Because Madoff’s funds had such cache, attracting the Who’s Who of the Jewish elite, others assumed that it must be a great fund. This irrational pack mentality is responsible for most economic bubbles, panics and schemes. Tufts not only gave money to Madoff, but paid Ascot Partners a 1.5 percemt commission to gain access to him, proving that it fell victim to that mentality.

5. Forget the myth of the magical hedge fund: Hedge fund managers have for years promised risk-fee astronomical returns, explaining them to be possible because of sophisticated calculations understandable by only a few of the world’s top economists. In reality, they usually just make heavily leveraged bets. Though they have world-class analysts advising these bets, it is still analogous to giving money to a world-class handicapper and asking him to pick football games. Because the market performed so well in the past two decades, hedge funds turned enormous profits. Now that the market has turned, the vast majority of hedge funds will go out of business. This is not to say that hedge funds have no future. Giving a skilled money manager a large pool of stable capital creates a significant advantage in beating the market. More importantly, given the assumption that markets will grow in the long run, investors that can afford to suffer during downturns in exchange for increased gains during prosperous seasons will profit from greater risk and greater reward as long as they remain properly diversified. When investors begin to realistically assess hedge funds, they will become more able to reap the benefits of that form of investing. As long as they maintain unrealistic expectations, they will fall victim to funds such as Madoff’s that promise unrealistic results. 

Mr. Nachbar is a senior majoring in Quantitative Economics.

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