#1 Investment Weekly – What he made off with

There are two important lessons from the Bernie Madoff Affair (besides the obvious such as: cheaters never prosper, where was the regulator and how did he do it): first diversify and second ignore the rhetoric.

Now that we have closure on the Madoff scandal, it is time to reflect on what went wrong. From an investment manager’s point of view, the overriding lesson is that the investors that placed their trust in Madoff’s promises did so with so much faith that they apparently forgot the first rule of investing: diversify. This is how the press seemed to have covered the story because the testimony delivered at the sentencing seemed to suggest that the investors that spoke had lost everything. If they had done so there would be no mention of “my daughter is holding down two jobs to pay for college” or “we don’t have enough money for food”. Let’s be clear: the people that left their life savings with Madoff had deposited large amounts of money. You had to be rich to invest with Madoff. Even if it was a feeder fund, you had to be wealthy. This was not a scam aimed at retail investors. These were wealthy, supposedly intelligent, people. So, he’s my first fire back at those investors: you deserved everything you got. The greed that consumed you into investing all of your life-savings with one investment manager was foolishness that deserved to be punished. As for the young woman having to work for her college degree, I would not be surprised to hear that she is actually feeling good about herself, almost normal, almost one of the crowd, instead of simply sailing through college knowing that if anything happened, she could always fall back on Mummy and Daddy’s wealth. The type of people that live off their parent’s success mostly grow up to be spineless creatures, who end up putting all their wealth into a ponzi scheme because they have no street smarts. For those that are now working to survive, I would say, great. This is good news for the US economy. It means that people that were very successful during their careers are now suddenly putting their experience and knowledge back into the economy at a time when the US economy needs all the entrepreneurial spirit it can get, as it grows its way out of the recession. These 50-60-somethings may well regret having to go back to work, but I didn’t hear of anyone saying that they couldn’t find jobs (despite the 9% unemployment rate). These people have connections, have done it once, and can do it again, and are more productive now than they were playing golf in Florida.

There is no doubt the press have had a field day covering the Madoff scandal, with headlines screaming about how terrible he was and how much he apparently stole large amounts of money. In a sense, Madoff was partly the Sheriff of Nottingham, and partly Robin Hood. He stole from the rich, but gave back to some other rich people. Remember, no money has actually been “lost”. Only the ones left holding the parcel when the music stopped have not received their capital back. It should also be remembered that those left by the wayside, received returns while they were in the scheme (even last year when the markets tanked). Are they planning on giving these returns back? Not likely. However, there are many, perhaps more streetwise investors, who would have invested and divested from Madoff funds. These investors are no where to be heard, and the press, as usual, consumed with their yelping headlines, have failed to find one former Madoff investor.

There are lots of data about how the scheme worked, some of which can be used (with some assumptions) to determine how the pyramid grew so large. We know that ~1,400 accounts were opened since 1995 and that total flows through the funds totaled US$160 billion, and that ~US$65 billion was active at the time of liquidation. Knowing the top of the inverted pyramid and how many bricks it was made from, we can paint a picture of what Madoff was doing. Assuming very tempting average returns of 8% a year, and after fees of ~US$260 million to himself, one can say the following: 1) he generated 100 new customers a year, each handing over US$10 million in AUM. 2) he must have already had US$40 billion in AUM in 1995 3) outflows could have been as much as US$700 million a year 4) but in the end Madoff’s funds on hand were equal to only 86% of the AUM that was supposed to be in the bank 5) this assumes he was paying 8% but also that he was making no returns – either because he made money in some years and lost in others (particularly in 2007-08). 6) Madoff paid himself a fee of only 0.004% on the AUM. The table below illustrates a best guess scenario.
Madoff’s pyramid

It is possible Madoff could have continued with the scam for quite a while before the coffers were completely empty, but I suspect he was overwhelmed by a tinge of guilt and a lot of panic.

Panic is something the bears are trying to instill into Hong Kong equities. They are talking up local interest rates as a focal point for their argument that equities are overvalued right now. Unfortunately, central bankers have a different point of view and the bears are not likely to win against the keepers of the purse. However, as long as they are trying to force the issue, equity prices will continue their current holding pattern within a narrow medium term upchannel.