How to Protect Yourself from Another Madoff

Madoff film tonight on HBO: A vital warning

Do you really know how your financial advisor is managing your money?

The Wizard of Lies, HBO’s new Bernie Madoff movie premiering tonight, is a harrowing reminder of how important it is to understand how your long-term investments are managed. While the film focuses on how the Madoff scandal impacted his family — his wife, his two sons, and his sons’ families — it also illustrates vital warnings and lessons in asset management.

You may wonder how those closest to Bernie Madoff, including his family and financial industry colleagues and partners, didn’t pick up on his fraud. Wealth managers, brokerages, investment advisors, and fund managers are heavily regulated by the Securities and Exchange Commission in the sale and management of securities. When $50 billion in assets goes missing, how does no one see the signs? And most importantly, what can we all learn from this?

The film’s co-producer Jason Sosnoff shares in an exclusive interview with DailyWorth: “You have to understand how Bernie was revered by his family and community. Everyone wanted access to his fund because they heard about the consistent returns. But then he’d limit the access. And that made people want to get in even more. People were joining his country club just to get close to him. And this created the myth. The myth that Bernie was a genius and you were lucky if he’d take your money.”

“The thing about myths is they usually get stronger over time. And then they’re like fact,” he continues. “And that’s what happened with Bernie. Imagine the kids growing up around this dynamic of everyone wanting access to their father. Perhaps it’s one of our flaws that despite all the data and analysis we now use in making decisions, at the end of the day we love to believe in myths. And in the case of Madoff’s sons, [it’s] the belief that the father is all-powerful, infallible.”

It’s an important point for those of us who grant some degree of blind trust to their financial advisors and 401(k) managers: When we see financial statements and portfolios with detailed asset allocations, how do we know that they’re real and honest?

Sosnoff explains. “[T]he main warning sign to those with more significant assets was that Madoff’s performance statements went in a straight line upward — showing annual growth of 12 percent per year. Investments never show consistent upward growth, but instead the normal ups and downs of the stock market. What was seen as Madoff’s ‘outstanding performance’ should have been picked up as impossible to achieve.”

But this fraud wasn’t detected until much later.

Madoff managed a large financial services firm that had multiple lines of business. The trading side of his firm, according to Sosnoff, was done so legally. But Madoff’s fraudulent brokerage, through which he stole $50 billion, happened one floor down on the 17th floor in a nondescript space occupied by only a few employees.

To make matters worse, a significant percentage of the funds Madoff managed were invested via other funds — such as pension funds, philanthropic trusts, and other financial advisors. Many of the victims didn’t know that their money was managed by Madoff because they only spoke to their direct advisor or feeder fund.

For example, one household’s hypothetical $500,000 portfolio would have been aggregated into a multi-hundred million dollar investment transferred to Madoff’s advisory. It would have been almost impossible for most, if not all, of the individual investors to review Madoff’s role in their funds management unless they uncovered how their funds’ funds were managed.

What steps can we all take to understand how our long-term investments are managed? Unfortunately as illustrated in this case, it’s sometimes very difficult to know, though there are layers you can and should investigate.

First, understand your investment advisor’s custodian and make sure that this custodian is reputable. All investment advisors and some broker-dealers use a custodian to hold their clients’ investments. According to Investopedia, “a custodian is a financial institution that holds customers’ securities for safekeeping to minimize the risk of their theft or loss.”

Madoff’s brokerage custodied its own assets. As a result of the scandal, the SEC passed new regulations to make it more likely that a misappropriation of funds by an advisor will be discovered. Examples of custodians include more recognizable brands such as Fidelity or TD Ameritrade, and lesser-known brands such as State Street and Apex Clearing.

Do your due diligence prior to investing your money with an advisor, whether that be a phone call, speaking with the firm’s other clients, or even a site visit. And if something doesn’t feel right, don’t be afraid to look elsewhere.

Jim Dowd, CFA (a board member of Worth Financial, the holding company of DailyWorth), ran the hedge fund advisory business at Bear Stearns a few years before the Madoff fraud was uncovered.

“[W]e were invited to invest with Madoff, and their track record appeared to be excellent,” he recalls. “But we had a due diligence requirement to make a site visit prior to any investment, and Madoff would not agree to it. That helped us avoid a grave mistake.”

Also, be sure to research your financial advisor’s public record. All registered investment advisors must file a form ADV with the SEC, which is a public record of all business operations, fees, assets, and in some cases, penalties or fines of they have any. You should also do a Google search, as older violations may not appear on an ADV. If you discover your advisor has a disclosure or penalty, you should ask him or her about it and decide for yourself: Is this person trustworthy? Some penalties occur due to mistakes or poor lack of judgement, with no intention to defraud you as a client, such as poor record-keeping or an undisclosed external personal investment.

In other cases, you may learn something that challenges your advisor’s ethics. After you review the penalties and discuss them with your advisor, only you can decide whether they’re an indication of whether you can trust them with your long-term investments.

Lastly, familiarize yourself with the typical ebb and flow of market patterns. All investments go up and down. If your personal portfolio’s performance report looks drastically different from a stock market index like the Dow Jones — such as showing consistent upward growth like Madoff’s fund — start asking tough questions to find out why.

According to Sosnoff, Madoff tricked everyone, even his wife and children. While it’s less likely you’ll fall prey to a Madoff-level Ponzi scheme, financial fraud is still a grave risk. This is why it’s vital that you begin to peel pack the layers of your investments.

Let your financial advisor know that you are watching and won’t stop asking questions until you get answers that satisfy and make sense to you.

The Wizard of Lies debuts on Saturday, May 20, at 8 p.m. on HBO. Starring Robert De Niro as Bernie Madoff, the film examines Madoff’s Ponzi scheme – his deception, lies, and cover-up, all as how the financier’s wife and sons are catapulted into a harsh and unrelenting spotlight. It’s based on the book “The Wizard of Lies: Bernie Madoff and the Death of Trust,” written by Diana B. Henriques.

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