One Useful Rule
which I learned 40 years ago, is all one needs to protect against the Bernies of the world
UPDATE June 29, 2009: Madoff is sentenced to 150 years. Talk show hosts and guests seem mystified how to properly conduct due diligence on a money manager. One Useful Rule is Step #1
UPDATE Feb 4, 2009: Harry Markopolis testifies before congress and advises the SEC to adopt my rule. If the SEC adopted this one rule, Madoff could not have done what he did.
When I was twelve years old, I recall sitting with the family at our dining room table with John Hotchkis, of Hotchkis & Wiley, puzzling over trust statements. Each year John flew to Carmel to review family investments. Not too many years later, I was responsible for allocating assets to managers. Before doing so, I studied historical cases to determine how to guard accounts. Those were back in the BG days ( 'before Google' ) so one had to actually do some work to find facts and data. I recall reading old periodicals in the Cal Berkeley business library. I compiled a list of common 'tells' in each reported scam, so I could watch for them in my due diligence. Number one on my list, which I've followed to this day, and if adopted as a rule by the SEC, would have saved the victims of current scandals, is this: Investment advisor and asset custodian must be separate.
If you, dear reader, are already familiar with this arrangement as a hallmark of prudence, you can move your mouse over to the right, click and read something else. If you are unfamiliar, read on.
Quick definitions: Investment advisor is the person responsible for researching investment themes, designing and impletmenting trading and risk control algorithms, making decisions on the trades. Asset custodian is the prime broker, brokerage company, or trust department, responsible for executing advisor's instructions, providing statements, confirms, balances, to the client. Simply put, the custodian is a separate entity which reports what happens to the money. Stockbrokers issue statements themselves, combining the function of management and custodianship, not the best check and balance.
Here is how I discovered this rule. In every case on record, the person responsible for investment and the asset custodian were in the same company, or even worse, the advisor issued the statements. While the overwhelming majority of managers are scrupulously honest and provide to-the-penny accounting, statements issued from the manager's office are a weakness in prudent financial controls, one link that the rare crook can use to his or her advantage. In the normal professional arrangement, the asset custodian sends statements directly to the client. There is no chance for the investment advisor to embellish them. That was a crucial weakness in the Madoff madness.
Does this mean one should never use a broker as an investment advisor? For my money, yes, because although most brokerage companies have good internal controls, it is not separate enough. There have been cases where a broker was able to skirt those internal controls and doctor statements. This just can't happen when the assets are at a separate organization.
Those managing any version of "pooled funds" tend to send out their own statements. These include many hedge funds, investment clubs, LLC's and limited partnerships. With the advances in brokerage services these days, where they facilitate 'block trading', there is no reason anymore to risk money in hedge funds or other "pools". It is just as efficient to keep money in one's separate account, and grant trading authority to a manager. By doing this, one keeps that independent accounting. Separate accounts provide more insurance. The SIPC does not insure hedge fund investors, but does insure individual accounts up to $500,000. How did my rule work out in practice? From the first Lloyd's Bank statement John Hotchkis handed me forty years ago, I've believed custodial statements have always been the normal way to keep track of investment managers. Funds I run are held by independent custodians: Interactive Brokers and Scottrade, and statements are available 24/7 online and are sent directly to clients. Squeaky clean. I suggest the SEC make this rule a requirement for all managed money. It would protect from the rare Ponzi problem. Much more common is the problem of honest managers holding investments well past their 'sell-by' date. But that's the subject of another article, titled Superior Returns from Average Indicators.