Wealthy & Wise:

Madoff-proof your portfolio

Establish a wealth-protection process to detect investment fraud early, writes Thane Stenner

Globe Investor Magazine Online January 29, 2009
Thane Stenner is managing director, private client, founder of Stenner Investment Partners of GMP Private Client L.P., and author of True Wealth: An Expert Guide for High Net-Worth Individuals (And Their Advisors). www.stennerinvestmentpartners.com

I had a working lunch with a client last week, a semi-retired entrepreneur with deep family connections to New York. He flies back several times a year on business and pleasure. For the sake of this article, we'll call him David.

On his most recent visit, David met with a close friend who had lost a good deal of money in the Madoff scandal. If you haven't been keeping up with headlines lately, Bernard Madoff is the New York financier alleged to have "made off" with nearly $50-billion (U.S.) in what may be the largest Ponzi scheme in history.

As David explained, his friend was a smart guy, with an Ivy-league education, a sizable investment portfolio, and decades of executive experience.

"If a guy that smart can be taken in," my client said between bites, "what chance do the rest of us have?" I responded with a simple financial truth: avoiding investment fraud isn't all about smarts. It's about process. Madoff targeted wealthy investors, international banks, charities, hedge funds, and money managers. These otherwise intelligent, financially savvy people lost large sums not just because Madoff was a criminal mastermind, but because they didn't have a wealth-protection process-a step-by-step system for detecting investment fraud before it happens. And if they did, they didn't stick to it.

Allow me to outline the wealth-protection process we use in our practice. While these steps are specifically geared to high net-worth investors with substantial portfolios, I believe almost any investor can put them to good use.

Diversify
I asked David how much his friend had lost with Madoff. The answer: About 30 per cent of his net worth. He wasn't alone. I've read some investors put as much as 100 per cent of their portfolio into Madoff's fund, trying to multiply their wealth in a short time.

What to do: Diversify your portfolio by asset class, by geography, by manager, and by investment strategy or style. Determine a maximum amount to allocate to any single investment - 15 per cent of portfolio value is a good target. Rebalance your portfolio to its target allocations at the start of every year. Make no exceptions.

Be cautious of anything hot, new or exclusive
Like many other Madoff investors, my client's friend was personally invited to invest with Madoff. The two met at an exclusive golf course just outside of New York, chatting for about 15 minutes-just enough time to be charmed (and flattered), but not enough time to ask any probing questions. Madoff generated this "aura of exclusivity" to feed the egos of investors while discouraging them from scrutinizing his investment strategy.

What to do: Don't cut corners on due diligence in an attempt to get in on a hot, trendy, new, or exclusive investment. Give such investments extra scrutiny and make a special effort to check facts and back-test historical returns.

One quarterback, many receivers
Madoff not only convinced investors to give him their money, he convinced them to allow him to manage their wealth. In essence, Madoff functioned as his own due diligence officer, his own asset manager, his own asset custodian, and his own auditor.

What to do: Separate the roles of wealth adviser and portfolio manager. It's like football: Your wealth adviser is the quarterback, deciding which receiver (portfolio manager) gets your money. As the quarterback, your wealth adviser is in control of the game, with the authority to take any receiver off the field at any time.

Layered due diligence
The third-party due diligence group my firm uses raised the red flag on Madoff as far back as 2002. Our own due diligence process uncovered some additional question marks. As a result, not one of my clients have been caught directly in the fallout. David's friend wasn't so fortunate. He assumed that because a family member, a friend, a celebrity, or a respected institution had given Madoff money, there was no need for further due diligence.

What to do: Insist on multiple layers of due diligence. First, ensure your wealth adviser does his/her own homework, checking in on managers monthly, asking tough questions, crunching numbers. Then, ask them to employ an independent third-party due diligence group to verify findings, as well as screen, monitor, and terminate managers on your behalf.

Trust, but verify
I asked David if he had ever heard of the firm Friehling & Horowitz. He shook his head. This obscure, three-person accounting firm operating from a one-room office was the one Madoff allegedly used to audit over $50-billion in client assets. I'm guessing most of Madoff's investors hadn't heard of them either, much less checked their statements.

What to do: Verify investment statements and returns by insisting that every portfolio manager you employ submit detailed reports and audited statements from well-known, reputable accounting firms. Incomplete reporting or undue secrecy should be cause for immediate follow-up. Unsatisfactory answers should be grounds for immediate termination. Transparency is important, especially as you become wealthier.

The golden rule
Madoff didn't promise sky-high returns. Year in, year out, Madoff's fund returned 10-12 per cent, no matter what the market was doing. Investors dream of this kind of uncanny consistency. But professionals have an extraordinarily hard time delivering it.

What to do: Live by the golden rule of investing: If it sounds too good to be true, it probably is.

Special to the Globe and Mail