Photo by AJ Alao on Unsplash

Bernie Madoff passed away in April 2021 while having served 12 years of his 150-year prison term for fraud. He will always be remembered for his Ponzi scheme, which essentially involved using money from new clients to pay for his lavish lifestyle as well as “returns” to other clients who were exiting the funds—there wasn’t any real investment. The collapse came when too many clients were exiting during the Financial Crisis, and he confessed to his sons, who turned him in to the authorities. There’s a silver lining: As investors, we can learn some important lessons that may prevent life-changing tragedies faced by fraud victims. Would you have given your money to the con artist? It won’t take long to get a sense of what you might have done.

Take This Simple 30-Second Test
Here’s a one-question multiple-choice test that I believe every investor should take (I’ll reveal the “answer” below—no peeking until you have chosen!). Considering how much risk you are prepared to take with investments for your retirement, if you had to choose just one of the following four assets, which one would it be? The first chart below shows reported returns over 18 years for the four different assets.

To help you in your decision, let’s consider the risk-return profiles, as each asset is quite different. Asset A is very stable, but the growth rate—as indicated by the slope of the line—is quite modest. Asset B does much better over the timeframe, but is more volatile. Asset C has a return between B and D, but its growth is incredibly steady. Asset D has the highest returns, but much greater volatility, and is less than half the value it previously was, on a considerable downward trend. Time to decide before you read any further!

Which one did you choose? When shown this chart, the vast majority choose asset C (although a few, the extreme risk-takers, go for D)—asset C is what I chose when I first saw it presented by my co-author In Pursuit of the Perfect Portfolio Andrew Lo at an academic conference, and most of my finance professor colleagues chose asset C as well. (This chart also appears in Andrew’s thoughtful and entertaining book, Adaptive Markets). Asset C appears to have a sweet spot of reasonably strong performance and incredibly low volatility. Fund managers would quickly observe that such an asset has a high Sharpe ratio (returns relative to variability), which is a very desirable attribute.

Now for a partial reveal: the time period is actually December 1990 to October 2008. Asset A is U.S. Treasury Bills. Asset B is the broad U.S. stock market. Asset D is Pfizer Inc., the pharmaceutical company, best known recently as the developer of one of the Covid-19 vaccines. Finally, Asset C is one you’ve probably never heard of, the Fairfield Sentry Ltd.’s investment fund, incorporated in the British Virgin Islands in late-October 1990, with $7.2 billion invested at the end of October 2008. Its shares were listed on the Irish Stock Exchange. Now that you know what the assets are, let’s take the chart out another six years:

Pfizer rebounded drastically, to new heights, as did the overall stock market, albeit with smaller gains (you may recall that October 2008 was during the depth of the Financial Crisis). U.S. Treasury Bills continued to provide modest and low volatility returns. But the value of Fairfield Sentry shares quickly plummeted to zero, along with all of your (hypothetical) retirement savings—you were wiped out if you chose it! What happened?

Now for the full reveal. It turns out that Fairfield Sentry mainly operated as the largest feeder fund into Bernard L. Madoff Investments Securities LLC (BMIS). On December 18, 2008, Sentry announced it was suspending the calculation of its Net Asset Value. It de-listed on May 28, 2009 and shortly afterwards, liquidators were appointed. Thousands of investors lost billions of dollars in one of the largest frauds in history, a fraud that lasted for at least 18 years. How could that possibly have happened? Oh, by the way, did you just choose to invest in it?!

A Credible-Sounding Investment Strategy
For a fraud to have lasted so long, there has to be a credible-sounding investment strategy, perhaps somewhat sophisticated, and there was. Fairfield Sentry described its principal strategy as “the utilization of a nontraditional options strategy described as a split-strike conversion” deploying most of its assets. There were three main parts to it: 1) buying a basket of 40-50 stocks that move closely with a broad market index, the S&P 100; 2) buying put options on the index (which puts a floor on price drops); and 3) selling call options on the index (which puts a cap on the upside). In theory, the cost of the put options should be offset by money received from selling the call options, and so the strategy should provide “market-like” returns (but probably a bit lower), with a bit less volatility. Is this completely clear to you? I suspect not.

After the fraud was uncovered, a couple of academics did a forensic experiment to show that the purported strategy didn’t add up. Carole Bernard and Phelim Boyle used stock market and options data from 1990 to 2008 to show the split-strike conversion strategy would have actually earned returns below the market, with a bit less volatility. What’s striking is that when they analyzed Fairfield Sentry’s reported monthly returns over that period, not only were Fairfield Sentry’s reported returns higher than the overall market, the volatility was less than one-quarter of what the replicating strategy suggested. So, the volatility was too low, and the Sharpe ratio (return-to-risk) was way too high. Then to put another nail in the coffin, the authors used sophisticated math to show that there was no way theoretically that Fairfield Sentry was able to obtain its reported returns by following the spit-conversion strategy. They concluded, “There are some simple quantitative diagnostics that should have raised suspicions about Madoff’s performance.”

Red Flags and Warnings
There were many reasons to trust Bernie Madoff. He had a strong reputation on Wall Street, with his firm one of the top market makers in Nasdaq stocks. He spent several years as chairman of the board of the Nasdaq stock exchange. He was charismatic. But there were numerous red flags, in addition to the surprisingly low volatility of returns, to indicate possible fraud.

The most vocal Madoff critic was Harry Markopolos, a derivatives analyst in Boston, who suspected the fraud as early as 1999. Markopolos made detailed submissions related to his claims to the Securities and Exchange Commission (SEC) in 2000, 2001, and 2005. The documents were either ignored or only studied briefly, and then the matter was dropped. It’s possible that the SEC was skeptical when Markopolos brought his initial claim since at the time his firm was competing against Madoff. Markopolos eventually became a full-time investigator, and wrote about the saga in the appropriately titled No One Would Listen. In addition, in 2001, Barron’s featured a story describing the Madoff skeptics and the secrecy surrounding the funds, and noted that over a dozen hedge fund professionals were unable to duplicate his returns using his strategy.

A paper by Greg Gregoriou and Francois-Serge Lhabitant succinctly describes the red flags, many of which were documented by Markopolos. From an operational perspective, there was a lack of segregation among service providers such as brokers executing trades, fund administrators, and custodians—instead, all of these functions were performed internally, with no oversight. The auditors, Friehling and Horowitz, were a three-person outfit virtually unknown in the investment industry, operating out of a small office plaza in New City, New York. The fee structure was unusual. The feeder funds never mentioned Madoff or BMIS. In regulatory filings, BMIS indicated it had $17.5 billion in assets under management, with a team of only one to five employees who performed investment advisory functions. Access to Madoff’s offices for due diligence was very limited or denied.

From an investment perspective, the strategy appeared to be a black-box because it wasn’t replicable as a split-strike conversion strategy. Madoff’s regulatory filing disclosures didn’t seem to be consistent with his purported strategy. Given the size of assets under management, there didn’t seem to be a trace of trading volume in the purported options traded.

What We Can Learn
Madoff’s Ponzi scheme was a tragic and sad story that impacted on the livelihood of thousands. It’s a cautionary tale for all investors. The Madoff scandal certainly wasn’t the first of its kind, and probably won’t be the last. But there are simple steps you can take and guidelines to follow to avoid or mitigate such risks of fraud:

• Ask questions and make sure you understand before you invest. There are many tried-and-true strategies that most investors are familiar with, such as investing in broad-based stock index funds like the S&P 500—that’s a low-cost strategy that Jack Bogle helped to pioneer. But if you are presented with the opportunity to invest in something like a “split-strike conversion” or an “alpha-enhancing delta-omega repo” (I just made that one up!) and you don’t understand what that is, then don’t invest in it—even if it’s with your brother-in-law.
• If something looks too good to be true, it probably is. I’m not aware of any true investments that provide returns like the Fairfield Sentry fund. Be skeptical of purported high return and low risk strategies.
• Like Harry Markowitz taught us, don’t put all of your eggs in one basket, like in one particular strategy or one fund that is of a specialized nature. (I’m not talking about a balanced fund with both well-diversified stock and bond funds.) And importantly, recognize the extreme risk of putting all of your 401(k) plan investments (or other similar retirement funds) in your firm’s stock—that certainly didn’t end well for Enron employees. Modern portfolio theory, developed by Harry Markowitz, shows us that in order to get higher expected returns you need to take on more risk and the only proven way to mitigate risk is through diversification—but even diversification won’t eliminate all risks.
• Be aware of your cognitive biases—we all have them. Bob Shiller reminds us that not all investors act rationally. With the optimism bias we believe that it’s not likely that we’ll experience a negative event. The Fairfield Sentry fund always did well (until it didn’t), with hardly any down months—why would that ever not be the case? Isn’t that one of the reasons you (probably) chose “Asset C”?
• Finally, you’ve probably seen this disclaimer before: Past performance isn’t indicative of future results. Reflecting on the Fairfield Sentry fund, need I say more?!

If you found the 30-second investment test informative, please spread the word, so that no one else will need to experience the pain that Madoff’s victims experienced.