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Trading Lesson: My Brush with Bernie Madoff
12/25/2017 6:00 am EST
The first thing I noticed was that all the trades were in the middle of each month. Each trade contained a purchase of an index fund, Alongside the trades were purchases of puts and calls, normally used to enhance return or protect principal, writes Steve Pomeranz, CFP.
Some time ago, I watched Madoff, the ABC movie about Bernie Madoff, which brought back a surge of memories I’d like to share with you.
It was circa 2004 when I got a call from a client just dying to sign up with Bernie Madoff. My client had been talking with a friend who had been in the Madoff fund since its inception in the 60’s and was arrogantly touting its many attributes.
This friend had invested $2 million-$3 million with Bernie Madoff and had also gotten others to do the same. He told my client he thought he could convince Madoff to invest his money since he knew Madoff personally and so had an “inside track.”
Rounding out the rest of this story, this friend had also involved the in-laws of my client’s daughter, and those in-laws had invested all of their money—plus their entire company’s bankroll into the fund.
A few days later, at my request, my client and his friend came back to my office with the Madoff statements so I could take a look.
The first batch of statements looked legitimate (like any other brokerage statement) but was missing some important details. When I asked if there was more, I was handed a large bundle of print-outs printed from an old dot-matrix printer. You know, the type of paper with the holes on each side! This print-out contained all of the trades going back a number of years.
I thanked them, and over the following days, I studied it all. The information on those sheets raised a lot of questions.
The first thing I noticed was that all of the trades were made in the middle of each month—different dates of the month but definitely clustered in the middle. Each trade contained a purchase of an index fund, which held the top 100 companies in the S&P 500 (SPX). Alongside these trades were purchases of puts and calls, which are normally used to enhance the return or protect the principal.
It didn’t make sense. How could anyone know what particular day to buy and sell these investments in order to achieve a consistent annual profit of 10%? There were only two possibilities, as far as I could see.
The first possibility was that somehow Madoff knew when large institutions were active in market buying and selling. If Madoff placed his own trades before placing his investor’s trades, he might be able to pull this off. I knew Madoff’s brokerage firm was a market maker, which is a firm that facilitates trading in a security and therefore sees customer order flow. So, bottom line: if he sees the order flow, he can get in front of it.
There’s only one problem with this—it’s illegal. It’s called front-running, and it is against the law for any broker to put his own trades ahead of a customer’s order.
That was a big red flag.
The other possibility was that it was all a fraud. I couldn’t wrap my head around this. Madoff’s name had been around ever since I could remember, and I had never heard any negative news surrounding him. The thought of a Ponzi scheme crossed my mind, but I couldn’t believe it.
Needless to say, I counseled my client against putting his money with Madoff. It turned out to be one of the best things I had ever done. Saving a client from disaster is a wonderful thing.
The worst outcome possible
What happened to the friend?
The friend, who had believed he was worth $8 million to $9 million (according to my client) and had received his original investment back through monthly dividends (of other people’s money, of course), ended up with nothing.
The in-laws were wiped out as well, along with so many others.
Further thoughts and takeaways from the Bernie Madoff tragedy
In 2009 or 2010, I interviewed Laurence Leamer, a terrific author in Palm Beach, who had written a book about Palm Beach Society called Madness Under the Royal Palms. He mentioned that the Jewish community in Palm Beach was very philanthropic. The season was filled with galas and balls all centered around fundraising for worthy causes.
He described the table talk of the guests at one of these charity events. You know, there are usually eight to ten guests at a round table discussing this or that, maybe politics, business, and so on.
Inevitably, the conversation turned to money and some bragging would ensue. One guy would say that his hedge fund manager had been up 28% last year. And, not to be outdone, another would say that his was up 34%, and so this discussion proceeded around the table.
The conversation came around to one guy who said, “Well, my hedge fund manager is very conservative. He doesn’t make these big returns; he just makes about 10% each year, year in and year out.”
Well, guess who his money manager was? Bernie Madoff, of course.
Not only were those in the small communities of Palm Beach hurt, but investors from all over the world were damaged.
The many charities that depended on the generosity of donors were hurt, too—not to mention the people whom they served.
Pension funds also suffered. For example, a pension fund of $290 million covering about 800 police, firefighters, and other employees in the Connecticut town of Fairfield, had around $40 million managed by Madoff.
Banks, insurance companies, foundations, colleges and celebrities all lost millions upon millions of dollars.
Sinister brilliance of a true sociopath
The lesson—and the sinister brilliance—of this particular Ponzi scheme is that the investment returns being touted were not outlandish.
It’s easy to detect a scam when someone is offering a 20% guaranteed return. Just compare that to a real guaranteed return, like the 10-year U.S. Treasury. Today that yield is under 2%. It is never possible to earn a guaranteed return substantially higher than the guaranteed rate.
But Bernie wasn’t offering an outlandish rate. The rate was not outlandish at all, but the consistency was. You cannot earn a 10% return every year. Your return can have an average rate of 10%, which means that some years you could be up 15% and others only up 5%, with the average being 10%.
Bernie’s other sinister trick was to create an air of exclusivity for those investors who felt they were members of a special club, which afforded them rarefied status in the community. They were the chosen few—insiders in the court of the legendary king.
So goes this tragic saga about a man who destroyed the lives of so many, including his own family and closest friends.
He left behind a scorched earth from which many will never fully recover.
Bernie left no one untouched or unscathed. He is a true sociopath.
To find out more, go to www.stevepomeranz.com
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