"In picture form, however, the returns are even more eyebrow raising. "

Here's a graph you should frame. From Bespoke:

"If You Ever See a Chart Like This, Run Away Fast

We've all heard how Bernie Madoff's returns sounded too smooth and consistent to be true. In picture form, however, the returns are even more eyebrow raising. The chart below shows the cumulative returns of $1 invested in the hedge fund Fairfield Sentry Limited, which was a fund run by Fairfield Greenwich Group that essentially directed all of its assets to the stewardship of Bernie Madoff. As shown, $1 invested in Madoff back in 1990 was supposed to be worth $6.75 today. NPB Bank, out of Zurich, even offered a version of this fund with three times the leverage. Talk about too good to be true.

"So let’s count the other red flags and see if they were numerous enough and obvious enough."

The Trader's Narrative with a list you won't want to check twice:

"After writing that Madoff offers the biggest due diligence lesson for investors, some argued that the red flags are only obvious in hindsight and wouldn’t have been if so clear if one had to make the decision before Bernard’s admission of running a Ponzi scheme. ( BS )

To be generous, I’ve assumed that the whole nature of the trading strategy, the inability of others to reverse engineer it, and the eerie equity curve it created, were not red flags ( THAT'S WAY TOO GENEROUS ).

So let’s count the other red flags and see if they were numerous enough and obvious enough. (The thumbnails are from the SEC’s website and clicking on them will take you to the larger version.)

RED FLAG #1
Madoff Investment Securities was both the broker dealer and investment advisor:

RED FLAG #2
Madoff traded in the same securities that he recommended to advisory clients:

RED FLAG #3
Madoff not only was the broker dealer, creating a conflict of interest where his firm was trading in the same securities as he was trading for clients, but he actually had custody of the assets!

RED FLAG #4
They got into some hot water over some small compliance issues. Madoff’s firm was censured and fined a small amount $7,000. But this meant they did have a blot on their records:

RED FLAG #5
Jim Vos, head of Aksia - a hedge fund advisory firm, noticed that although Madoff’s firm was supposedly highly advanced and automated, they sent paper copies of their trading records to clients instead of providing electronic access to the firm’s trading platform.

RED FLAG #6
Madoff Investment Securities’ auditors were Friehling & Horowitz, a 3 person team which consisted of one lone CPA with a small 13′ by 18′ office in New York. Hardly adequate to monitor a firm that traded a good chunk of NYSE and NASDAQ volume.

RED FLAG #7
Shockingly enough, Madoff didn’t take the usual 2/20 fees most hedge funds do. Instead he only profited from the trades that his firm was doing for the “investment fund”, claiming that this was enough. Given this form of compensation, it is very possible most “sophisticated investors” assumed that Madoff was involved in some sort of shenanigans but turned a blind eye for those stable returns ( WISHFUL THINKING AND GOVERNMENT GUARANTEES ).

Here’s an excerpt from a 2001 Barron’s article on Madoff Investment Securities secrecy:

Curiously ( IMPOSSIBLY ), he charges no fees for his money-management
services. Nor does he take a cut of the 1.5% fees marketers like
Fairfield Greenwich charge investors each year. Why not? “We’re
perfectly happy to just earn commissions on the trades,” he says.

Perhaps so. But consider the sheer scope of the money Madoff would
appear to be leaving on the table. A typical hedge fund charges 1% of
assets annually, plus 20% of profits. On a $6 billion fund generating
15% annual returns, that adds up to $240 million a year.

The lessons of Long-Term Capital Management’s collapse are that
investors need, or should want, transparency in their money manager’s
investment strategy ( YOU THINK ? ). But Madoff’s investors rave about his performance
– even though they don’t understand how he does it ( WISHFUL THINKING AND GOVERNMENT GUARANTEES ).

RED FLAG #8
Madoff Investment Securities was a family business, with Madoff’s brother, sons and daughter as well as his niece (married to a previous SEC compliance officer) all worked at the firm.

“All of his family members grew up with this being our lives. When it is a family operated business you don’t go home at night and shut everything off, so you take things home with you, which is how all of us grew up”

Mark Madoff (pictured on the right with his father, Bernard L. Madoff, left)

Peter Madoff, pictured below, was a senior managing director and head of trading and compliance at Madoff Investment Securities. He began at the firm in 1965. With so much family involvement, one can’t help but ask how much they knew and if it was even possible for one lone patriarch to organize, control and maintain such a huge fraud all by himself.

Click to see large version:

Aksia LLC, broker dealer, due diligence, fraud, hedge fund, Jim Vos, Madoff, Madoff Investment Securities, ponzi scheme, public disclosure, SEC

The reasons that investors took these risks were Wishful Thinking and the Government Guarantees.

"It would be very hard for most hedge funds to operate Ponzi schemes, as Mr Madoff is alleged to have done."

I have to admit to being a defender of Hedge Funds, even though, like CDSs and CDOs, I wouldn't invest in them myself ( largely due to lack of resources ). Here's John Gapper in the FT with some interesting news:

"The alleged fraud of $50bn at Bernard Madoff’s investment advisory business will send a scare through the fund-of-funds that put investors’ money in hedge funds in return for a fee, but the implications for hedge funds are less obvious.

His business, although hedge fund-like, was not structured like most hedge funds, and there would have been more safeguards if it had been. It would be very hard for most hedge funds to operate Ponzi schemes, as Mr Madoff is alleged to have done.

This paradox cropped up in the New York Time story on the scandal on Friday. Early in the piece, it said:

The collapse of Mr Madoff’s firm is yet another blow in a devastating year for Wall Street and investors. While Mr. Madoff’s firm was not a hedge fund, the scope of the fraud is likely to increase pressure on hedge funds to accept greater regulation and transparency and protect their investors.

Further down, however, it added:

Mr Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JP Morgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.

Well, indeed. Long-running financial frauds often depend on the same person having control of the front and back office - not only making trades but having oversight of clearing and settlement. If Mr Madoff was engaging in fraud, as alleged, it was very helpful not to have others checking on his trades.

The problem is less for hedge funds than for funds-of-funds. Some, including Fairfield Greenwich Group and Tremont Capital Management, directed money to Mr Madoff’s fund management arm and got fees for it, but do not seem to have grasped what was going on."

I think that it's very important to be specific and accurate in using terminology. This is not a Hedge Fund Problem according to Gapper.