A few years ago, a relative asked me to manage his money.  I have a rule against managing family money, for obvious reasons, but this relative was rather insistent.   His current advisor was retiring, and intended to hand off his account to an advisor new to the business (someone who, incidentally, had been a Big-O Tire salesman a year earlier).   

 I directed my relative to my website, and suggested that he read past Commentaries, so that he could make sure he was comfortable with my style and approach to the markets.  He felt that was unnecessary, since he was sure I would do a great job, and besides, the whole point of an advisor was never having to think about such stuff.  I explained that a little discussion now would head off potential misunderstandings in the future, and that I would not accept his account until he at least read a few of my Commentaries.

He wouldn’t do it.  He subsequently went with the tire salesman.

Lest my relative appear particularly foolish (a fact I’m not arguing against, either), this nature of interaction is not uncommon.  In the nine years I have run money professionally, in an industry overrun with consultants, experts and armchair quarterbacks, I’m not sure I have ever met a sophisticated investor, even among other professional managers.  Since I assume every adult approaches life with some degree of wariness, it is fascinating that Madoff targeted the financially sophisticated – advisors, hedge funds, and institutions.  It is said that fear and greed (and I might add, laziness) are stronger than long-term resolve, and it is almost reassuring that human nature never changes.  If I were a lesser man, I might be smirking right now.

Of course, now the pendulum has swung hard, and I’m reading articles on how you can’t trust anyone.  Resume isn’t enough.  Experience and references are not enough. Bill Miller, a lengendary manager, had his first losing year.  His prior eighteen years of outperformance has now been dismissed as just a lucky streak.

This is pretty dumb as well.  The biggest (financial) losers I know are people who never trust anyone, who see a con at every turn.  Ultimately, life must be lived in good faith, that the rules will ultimately apply.

 But the question remains:  how did Madoff get away with it?  By giving the customers what they want.  And on a certain level, it was a brilliant bit of marketing.

 The hardest part of managing other people’s money is often… the other people.  Investment returns are, by their nature, lumpy.  They do not come regularly, and safely, like interest payments from a bank account.  But it is axiomatic that most clients are long-term investors – as long as they make money every quarter.  In a bull market, there are comments that an index fund would have been just as good, and a lot cheaper; in a bear market, well, the manager should have been more conservative.  And it is not only the smaller investor; the larger sophisticated investor is often worse.  Consultants evaluate money managers on both returns and volatility:  smooth returns are good; volatile (real world) returns are bad.  Hedge funds generally report every month; however, some clients expect weekly updates, and Jim Cramer wrote that he once had investors calling several times a day.

 This is why many successful investment partnerships and hedge funds do not accept outside money.  They can no longer bear the headaches.

 But if a money manager is looking for outside money, we in the industry all know that a track record of smooth, consistent returns will bring clients beating down the door.  In fact, it has been expressly stated that the holy grail of performance is a steady one percent per month – which is exactly what Madoff delivered.  The clients knew better, without a doubt.  But they preferred to believe the lie.

 The case does bring forth two useful points worth noting:

1. Many of Madoff’s investors had no idea they were Madoff investors.  That’s because their money managers are not money managers.  They are salesman on commission, who charge a fee simply to place the money entirely with someone else.  In fact, the majority of money managers are actually just middlemen (the industry term is “asset gathers”).  This is not necessarily wrong, or bad.  But many “advisors” are vague in this disclosure, lest they lose stature in the eyes of their clients.  And you will be charged twice, and may not know exactly where your money is.
2. Custodians versus advisors.  This one really stumps me.  Any legitimate advisor uses a third-party fiduciary.  For example, I use T.D. Ameritrade.  I can make trades, and request withdrawal of my fee every quarter.  Otherwise, I cannot touch the money.  A client wishing a withdrawal must contact Ameritrade directly.  Ameritrade issues its own quarterly statements.  It protects the client and the advisor.  Any other arrangement, by definition, screams of potential fraud.  It just isn’t done.