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The Bernard Madoff Scandal
Bernard Madoff seemed like one of the great success
stories in the annals of finance. His asset management
firm, Bernard L. Madoff Investment Securities, reported
to its clients that their investments of around $20 billion
were worth about $65 billion in 2008. But that Decem-
ber, Madoff reportedly confessed to his two sons that he
had for years been operating a Ponzi scheme. A Ponzi
scheme is an investment fraud in which a manager col-
lects funds from clients, claims to invest those funds on
the clients’ behalf, reports extremely favorable investment
returns, but in fact uses the funds for his own purposes.
(The schemes are named after Charles Ponzi, whose suc-
cess with this scheme in the early 1900s made him notori-
ous throughout the United States.) Early investors who ask
to redeem their investments are paid back with the funds
coming in from new investors rather than with true earn-
ings. The scheme can continue as long as new investors
provide enough funds to cover the redemption requests
of the earlier ones—and these inflows are attracted by
the superior returns “earned” by early investors and their
apparent ability to redeem funds as requested.
As a highly respected member of the Wall Street estab-
lishment, Madoff was in a perfect position to perpetrate
such a fraud. He was a pioneer in electronic trading and
had served as chairman of the NASDAQ Stock Market.
Aside from its trading operations, Bernard L. Madoff
Investment Securities LLC also acted as a money manager,
and it claimed to achieve highly consistent annual returns,
between 10% and 12% in good markets as well as bad. Its
strategy was supposedly based on option hedging strate-
gies, but Madoff was never precise about his approach.
Still, his stature on Wall Street and the prestige of his cli-
ent list seemed to testify to his legitimacy. Moreover, he
played hard to get, and the appearance that one needed
connections to join the fund only increased its appeal.
The scheme seems to have operated for decades, but in
the 2008 stock market downturn, several large clients
requested redemptions totaling around $7 billion. With
less than $1 billion of assets left in the firm, the scheme
collapsed.
Not everyone was fooled, and in retrospect, several red
flags should have aroused suspicion. For example, some
institutional investors shied away from the fund, objecting
to its unusual opacity. Given the magnitude of the assets
supposedly under management, the option hedging trades
purportedly at the heart of Madoff’s investment strategy
should have dominated options market trading volume,
yet there was no evidence of their execution. Moreover,
Madoff’s auditor, a small firm with only three employees
(including only one active accountant!), seemed grossly
inadequate to audit such a large and complex operation. In
addition, Madoff’s fee structure was highly unusual. Rather
than acting as a hedge fund that would charge a per-
centage of assets plus incentive fees, he claimed to profit
instead through trading commissions on the account—if
true, this would have been a colossal price break to clients.
Finally, rather than placing assets under management with
a custodial bank as most funds do, Madoff claimed to keep
the funds in house, which meant that no one could inde-
pendently verify their existence. In 2000, the SEC received
a letter from an industry professional named Harry Mar-
kopolos concluding that “Madoff Securities is the world’s
largest Ponzi scheme,” but Madoff continued to operate
unimpeded.
Even today, several questions remain unanswered. How
much help did Madoff receive from others? Exactly how
much money was lost? Most of the “lost” funds represented
fictitious profits that had never actually been earned, but
some money was returned to early investors. How much
was skimmed off to support Madoff’s lifestyle? And most
important, why didn’t the red flags and early warnings
prompt a more aggressive response from regulators?
WORDS FROM THE STREET
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P A R T V I I
Applied Portfolio Management
The idea behind funds of funds is to spread risk across several different funds. However,
investors need to be aware that these funds of funds operate with considerable leverage,
on top of the leverage of the primary funds in which they invest, which can make returns
highly volatile. Moreover, if the various hedge funds in which these funds of funds invest
have similar investment styles, the diversification benefits of spreading investments across
several funds may be illusory—but the extra layer of steep management fees paid to the
manager of the fund of funds certainly is not.
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