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January 5, 2009

Are You Madoff Proof?

muller_moritzBernard Madoff ran the biggest “Ponzi scheme” in history.  He stole billions of dollars from well-healed investors, institutions and charities.  His malfeasance went undetected for years.  How did this happen?  How do you make sure it does not happen to you?

Mr. Madoff was a long-time Wall Street insider and former chairman of the Nasdaq stock market who used his status to bilk investors.  He claimed he had a unique investment system involving options (puts, calls and collars) that consistently produced amazingly high returns that beat the market.  In fact, he was simply using new money to pay off liquidations while he swindled the rest.  He used phony, mocked up statements and returns to fool investors.

Mr. Madoff’s Ponzi scheme was easier to commit because of the lax rules involving “accredited investors”.  These investors included wealthy individuals, institutional investors, charities, foundations, banks and other hedge funds.  The law considers these investors to be sophisticated enough to make investment decisions without the same amount of disclosures, filings and protections provided to the rest of us.  This often works in the accredited investor’s favor.  They are able to get into deals we can’t.  The lower filing and administrative costs associated with these deals are usually passed along to the accredited investors.  But this time, it backfired.  Mr. Madoff’s hedge fund was all smoke and mirrors.

Hedge funds are private investment pools for accredited investors.  Since investors are accredited, the hedge fund manager is not required to follow any investment strategy nor are they prohibited from using any specific investment.  Hedge fund managers do not have to answer to a board of directors.  They are literally the “wild west” of investments.  The management fee starts at 2% and goes up to 30% on a performance-based.  The disclosure and reporting requirements are far less than traditional investment vehicles, like Mutual Funds, Unit Trusts, and Variable Annuities.  In this case, Mr. Madoff used his connections to entice other hedge fund managers to put part of their funds in his hedge fund.  So it went until it all exploded in December.

Six Safety Measures

First – Never give custody of your assets to an investment professional.  Insist on using a third party custodian. At Money Concepts, we use Pershing, LLC (a subsidiary of Bank of New York Mellon) and/or Fidelity Investments.  They hold all clients’ accounts.  They maintain all books and records for the client.  They are also responsible for sending out confirmation and statements.  Any fund withdrawal must be directed to the custodian and sent to the client’s address of record.

Second – Take advantage of the regulations and security laws that are in place to protect you. There are a myriad of investment choices available.  Use the investment vehicles that are covered by these regulations.

Third – Understand what you are investing in… if it sounds too good to be true it probably is. If your investment advisor can’t explain it, don’t buy it!  Investing is tough enough.  Good quality investment programs go down in a bear market.  Don’t be fooled by someone selling easy returns or “pie in the sky” type numbers.

Fourth – Review any prospectus carefully. If the investment does not “require” a prospectus or has a “limited prospectus”, RUN, don’t walk.

Fifth – Always use more than one money manager. Any investment advisor worth their salt has a multitude of good money managers to choose from.  He or she should work with you to put together a “team of money managers” to handle your accounts.

Six – Communicate with your advisor before, during and after investing. Making an investment decision is just the start.  Good, open communication can help you make better, more informed decisions in the future.