Hedge fund investing

Lessons from Madoff’s Ponzi Scheme

Madoff carried out one of the largest and longest running frauds in Wall Street history. However, there were many warning signs and improper tactics that wouldhave alerted prudent clients. Two major lessons can be learned from the fraudulent activities of Madoff. 1. Tremendous value is added for clients by firms that take the moral, ethical, and legal highroad. 2. Investments, even with the best managers, will tend to have up and down periods. Therefore, if it sounds too good to be true, it likely is. This paper presents some of the lessons andinvesting principles that I ascertained from this scandal.

- Trading strategy should match the returns
Madoff securities employed a simple investment strategy of purchasing stocks and subsequentlytrading options contracts in order to limit losses on the long stock positions. However, this strategy is highly unlikely to produce positive returns in a severe down market. Madoff’s secret tradingstrategy supposedly made money in all markets and experts could not explain how he produced consistent returns with a “black box strategy. Comparing the reported returns with the returns of the relativeinvestment vehicles would help investors highlight any fraudulent activities.

- Comply with basic asset allocation and diversification guidelines with investments
A diversified portfolio helpsmitigate market down turns but also protects clients against catastrophic loss. Clients who had 100% of their money allocated to Madoff have conceivably lost everything. Those investors who had asignificantly lower percentage of their investable money in Madoff’s fund will eventually recover.

- Review third party audits of hedge funds from a reputable accounting firm
Madoff used a small 3 personaccounting firm operating out of a strip mall. Investors should insist on a major account firm’s independent audit and closely analyze the audited statements. Firms registered with SEC maintain...