We are not going to delve into endless discussions of how Bernie Madoff has successfully managed to defraud hundreds of investors for years. We will not talk about the reasons of the SEC’s dereliction, when the latter was supposed to examine the Madoff’s books since 2006. All these aspects are largely irrelevant for us.
What really matter is how highly respected financial institutions (for example, Credit Swiss) invested billions of dollars into the Madoff’s scheme without conducing any basic due diligence.
Oh, sorry, it is not correct. Of course, they had conducted full due diligence; everyone familiar with the institutional asset allocation process knows that it is impossible to make any new investments unless a huge paperwork burden is in place - including numerous investment committee approvals. A million dollar question: what is a typical institutional due diligence process worth, if it cannot spot a trivial Ponzi scheme?
Let’s stress it again: we are not talking about HNWI or any individual investors that could be easily misled. We are talking about top-grade institutional investors with virtually unlimited resources and long established routines. Why did they fail? The answer, at our opinion, is obvious:
The common institutional due diligence on hedge funds is solely based on formal (and largely worthless) questionnaires that disregard a coherent trading strategy analysis. A fairly basic examination of employed strategies and/or employed risk management frameworks would spot such a Ponzi scheme instantly.
By prioritizing the know-my-managers factor, the employed check-up practices (if any) mostly neglected any other elements of the Madoff’s investment process. His funds even never used an independent custodian, which itself was supposed to raise a red flag immediately. However, no one questioned this. How could one doubt anything? The only Madoff's name itself was sufficient to build unlimited confidence.
The bottom line is simple: the Madoff’s case clearly illustrates inability of institutional investors of conducting any coherent due diligence, which, in turn, derives from inappropriate frameworks used. On the other hand, this case exposes a common practice of investing primarily based on personal industry contacts ("we know that guy"). While we cannot argue a great importance of such personal contacts, disregarding other factors always lead to Madoffs’ scams. Unless we see radical changes in institutional due diligence and hedge fund risk assessment practices, we should expect more and more similar cases, especially during uncertain times.
ABC Quant Follow Up
This article was published back in 2009. Since then many of our clients were asking - how using Quant Suite or Risk Shell platforms could have prevented investing into the Madoff's fund. So, we have created a special study of applying our Factor & Style Analysis techniques to the Madoff's fund and also conducted a number of webinars dedicated to that particular case. We have demonstrated that it takes about 15 minutes to exposure the fraud and spot significant irregularities in the Madoff's declared strategies using our Factor Analysis component. Furthermore, we have developed a special tool, Risk Statistic Inconsistency Exposure, that alone could raise a red flag on the Madoff's return series. Finally, the Advanced Factor Analysis and exposing return inconsistencies are parts of the ABC Quant Due Diligence framework (see Due Diligence). If our Due Diligence system had been used by top institutions, the Madoff's fraud would have been exposed during the 2nd step of the process.