Madoff's mess

Even by the standards we've become used to during these interesting times, the fraud uncovered at Madoff this weekend is rather staggering. Having built up his pyramid scheme on the capital of wealthy US investors (in particular from Florida), Madoff snared them all. Reports hitting the wire today are reporting several institutional investors being caught in this pickle - BNP Parisbas, Santander and Pioneer to name a few.

I'm not sure whether this has anything to do with the Irish government's sudden decision to prop up its listed banks with a massive recapitalisation effort. People have been asking me this weekend how "sophisticated" investors could have fallen for Madoff's scam.

The reality is that investors tend to get seduced by the "investment" story (track record, strategy etc). It creates this weird mindset where people get so excited by the idea that they get too lazy to do the (boring) due diligence that is vital to weeding out the crooks. An unglamourous task, but essential to preserving wealth.

The worst offenders are actually so-called "sophisticated" private investors who setup their own family offices. Think of the toy train version of asset management. You have people with far more money than sense, who often have never had to work in truly commercial settings (if they did, they only got the job through their father/mother's good offices). They hear about "smart investors" putting money with a fund manager, who seems to generate great returns. They pile in with little or no time spent actually kicking the tires.

One example springs to mind. I bumped into the son of a wealthy patriarch on Friday, who was whining about being caught in a similar situation. I asked him how he'd decided to invest. "A very good friend who invests his own money recommended it", came the response. I then asked what analysis he'd done of the manager's middle and back office operations. A blank stare. Come on, you did ask for an operations manual? "No". Not even an audit of some recent trades? "No".

I have trouble sympathising with such amateurs. Yes, Madoff appears to be a fraudster according to the news, and if proven he should be held accountable for that. Yet supposedly "sophisticated" investors wrote their cheques without the most basic due diligence. This may sound unfeeling, but let this be an abject lesson to these people - don't have delusions of grandeur. It's the quickest way to erode your wealth.