01.14.2009

Assuming you've not been in hibernation lately, you're familiar with the tragedy known as the "Madoff Swindle."  Although seemingly beyond imagination, the media reports that Mr. Madoff has defrauded individual and institutional investors out of upwards of $50 BILLION!

For a variety of reasons (discussed below), Integrated Wealth Management and our clients have no direct exposure to any Madoff investments and, having reviewed our entire investment universe, we do not believe that there is any secondary or tertiary exposure.

I've been asked by numerous people how an investor would have known to avoid this debacle, why we were not invested with Madoff and what should someone do in the future. The answer is deceptively simple. In addition to a review of past performance, our due diligence process (i.e., the process we used to determine what managers to hire for our clients' portfolios) has three elements we call the "3Ps"

After a manager has passed these tests, only then do we look at his or her past performance. Not just the last few years but how did they do during good and bad markets; was their performance appropriate and credible?

How does this process relate to Mr. Madoff? Well, his purported option strategy passed Test #1. As described in the media, it was credible and not particularly complex.

Test #2 would have been a bit more problematic. Although the strategy was indeed credible and not too complex, it was also reasonably common. That raises the question of how anyone could, net of fees and expenses, consistently outperform other professionals.  For Madoff part of the answer was the claim that the firm was technologically advanced. Unfortunately, as Aksia, an Advisory firm who had vetted and rejected Madoff, noted "The managers had no demonstrated electronic access to their fund accounts at Madoff." The final and most critical hurdle in Test #2 relates to the operational management of the firm. It seems that Mr. Madoff not only managed the assets, his firm also traded and custodied the assets. As any securities attorney will tell you, having the fox guard the hen house is, at a minimum, a serious red flag. One element of protection (although obviously not full proof) is to look for audited reports. And, indeed Madoff had audited reports. Unfortunately, the auditor was not a name brand firm; it was a tiny three person office with only one full time professional.

Test #3, looked good on the surface, as Mr. Madoff had a long and seemingly distinguished career in the investment world.  Unfortunately, a closer look would have shown that Bernard's brother Peter was a senior managing director and chief compliance officer and Peter's daughter was the firm's compliance attorney. Also, Bernard's son Andy was director of trading and his son Mark was director of proprietary trading.  Given the firm's control over both trading and custody, this family oligarchy would make the red flags awfully bright.

Supposing an investor had been comfortable with a manager passing these tests, the next hurdle would be to evaluate past performance. For us, this alone is often the fatal flaw.  For example, it seems that Madoff's portfolios did very well no matter the performance of the broad equity market.  Although it is possible for hedged portfolios to mitigate downside losses, without significant leverage, that safety comes at the cost of upside performance. For a hedged manager to achieve a high level of positive returns when no other manager can, raises the obvious thought "if it's too good to be true, it's probably not." 

If, at this stage, an investor was still enamored of the opportunity there would be two additional steps. Revisit Tests #1 - #3 to insure a comfort level with the substance behind the seeming unrealistic performance track record and, if still satisfied, diversify; LIMIT the investment to no more than 5 - 10% of the portfolio.

As a result of our firm's general avoidance of many of the investment world's hot stories of the last 10-minutes and "sophisticated" alternative investments (e.g., auction rate funds and CDOs), over the years I've heard rumblings that our firm has been referred to as "conservative."  Although obviously a bit biased, I've always believed that our due diligence process and diversification is intelligent not conservative (at least not in the pejorative sense).

As I've often told anyone willing to listen, if we knew how to mint money in the market without risk, we wouldn't bother working for a living; we'd simply be enjoying great wines sitting on the deck of our yachts. We don't believe in the tooth fairy, free lunches or pots of gold at the end of the rainbow; we do believe that over economic cycles, investors will get returns appropriate to the risk they are willing to take. 

What Mr. Madoff did to his investors was unconscionable. It is a public tragedy for all investors and personal tragedy for many and our hearts go out to everyone affected. The only possible positive result will be if investors learn to avoid future disasters by remembering common sense and the 3Ps.  Bottom line, we take great pride in being the investment turtle not the hare and recommend that approach to all investors.

Sincerely,

Jim Casey
President & CEO