Friday, December 12, 2008

It's Not Rocket Science

As the details begin to emerge about a Guinness Book of Records-size Ponzi scheme by Bernie Madoff's "asset management" company, there were two interesting items about investors who passed on giving assets to the Madoff funds. In some cases they hired firms to perform due diligence. So, did these investigative firms send in laptop-toting, analysts with high-powered statistical packages to back test the firm's strategies? Not at all. They asked the very basic, but penetrating questions.

One firm simply looked at the name of the accountants overseeing the financial reporting for Madoff's $50 billion in assets under strategies that involved indexes and options. They actually called and then visited the accountants and discovered a three person firm, one of whose principals was 78 years old and lived in Florida (the office was in New York). You don't need to turn this over to your risk management committee. It makes no sense, smells bad, and it is highly improbable that they could exercise the proper level of auditing oversight and control. The investigative firm recommended that their investor pass. Bravo!

Another item relates to a simple thinking through of the most basic conflict of interest, namely the trustee that held the securities for the asset management business was indistinguishable from Madoff's entire enterprise. So, this investor rightly concluded that it would be extremely difficult, if not impossible, to independently verify the existence of assets, especially cash which had seemed problematical during several reporting periods. Simple, clean, elegant logic. Maintain independence and verifiability. Avoid conflicts. This same market professional wrote a letter to the SEC of his findings and characterized Madoff's investment firm as a Ponzi scheme in 1999.

Academic research has talked about why people sell winners early and hold onto losers for too long. One of the theories can be summarized by the phrase, "Pride and Regret." This phrase can also apply to the due diligence process for buying into alternative type investments. If you have to ask silly questions, like "Who holds the assets, and are they independent from you, the manager?" you probably don't have the native intelligence, didn't go to the right schools, and are otherwise not worthy of the high returns that are being handed out. Nobody wants to feel like they are unworthy, that is basic pride. Similarly, suppose that a friend at a cocktail party points out that she has never heard of your hedge fund accountants. You might start to feel a twinge of regret, not to mention anger at someone raising something that seems obvious after the fact. "Could she be right? Did I make a bad decision?" It's much easier to assuage the regret by feeling that you will surely cash out before anything catastrophic happens. Or, the "SEC and the regulators watch out for this stuff." Other rationalizations abound, but they revolve around "pride and regret."

Emotions still matter in the matters of money and markets.

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