Netflix’s series "Madoff: The Monster of Wall Street" was harrowing viewing – the stories of investors losing everything were hard to watch. But it served as an opportunity to reflect on the immense responsibility placed on the global financial industry to protect investors through rigorous due diligence and to uphold our obligation as stewards of their capital. Let’s look at some key lessons to take from the series.
If It’s Too Good to Be True ...
According to Harry Markopolos, the whistleblower in this tragic tale, the “numbers were literally off-the charts good” and Madoff produced a return stream that “simply doesn't exist in finance”. The positively consistent and sometimes outsize returns reported to investors – and the mismatch between the stated investment strategy and the return profile – were undoubtedly red flags. The quantitative analysis Markopolos conducted, showing that over 96% of monthly returns were positive; correlation with the stock market was negligible at around 6%; and the Sharpe ratio [a measure of risk-adjusted returns] was outsize, ranging between 2.5 and 4.0 for most time frames, was literally unbelievable.
While quant analysis, such as risk/reward metrics relative to peer performance or appropriate benchmarks, can be dismissed as overly simplistic, it can provide a useful trigger for further investigation. Madoff’s compelling narrative was powerful and swayed many investors. But quant analysis can be viewed independently of a fund manager’s “narrative,” which may help reduce our human biases that arise in face-to-face interactions. Ultimately, if an investor is generating returns that just seem a little too good, it’s time to take a closer, impartial look.
No-One Should Be Beyond Reproach
The documentary insinuates that many investors, both professional and individual, desperately wanted the returns to be true, and this seemingly clouded their judgement and preparedness to delve more deeply. Investors and regulators alike were blinded by Madoff’s “big dog” status on Wall Street. Madoff was involved in the industry and spent time working with the US Securities and Exchange Commission (SEC), and this persona seemed to provide a shield from detailed investigation earlier on in the fraud. Madoff’s seeming ability to manufacture mystique and secrecy compounded the problem.
According to Markopolos: “No-one asked tough questions and people settled for half answers or no answers.” Curious scepticism is an important trait for participants in our greater than trillion dollar industry, and we should be prepared to thoroughly question and demand transparency from even the biggest and most high-profile industry participants. While it is inevitable that high-profile, trusted participants emerge and a sense of community exists amongst the industry, no-one should be beyond reproach.
A Well-Funded Regulator With a Clear Mandate
The need for a well-funded regulator with teeth and a preparedness to investigate red flags raised by industry participants was a key takeaway. Markopolos flagged issues to the SEC in 2000, 2001, and 2005. And the SEC investigations conducted were portrayed as either superficial or inadequate based on the level of experience of the investigators. Industry lone wolves flagging issues can prove invaluable – the cries of these courageous individuals should be heeded. Ensuring that our regulators have the required funding to do their jobs properly and investigate whistleblower claims, but also attract quality, experienced professionals to undertake these investigations, is critical to protect investors.
Spotting Anomalies Requires Data
It’s clear that Madoff’s risk/reward metrics were outliers and could have been systematically flagged as anomalous as part of an ongoing monitoring process. Further, the mismatch between the stated strategy, the estimated size of the strategy, and the depth of the options market didn’t reconcile. Nor did his willingness to not charge fees to certain clients. Obviously for any external monitoring to occur, the data would need to have been transparently provided by Madoff.
Transparency was not his forte. And the fact Madoff hadn’t registered his investment advisory business would have absented the firm from ongoing data provision that could have potentially flagged in more due-diligence processes. Without data provision, any sort of systematic monitoring is very difficult. At Morningstar, an area of development for 2023 is how we can improve our anomaly detection capabilities to spot outliers throughout the fund universe.
2023 and Beyond: A Great Responsibility
Watching the investors harmed by this fraud was sobering. But this history lesson is valuable. Evolving our due-diligence processes to better identify anomalies on both a one-off and a cumulative basis is critical, as is managing our human biases when it comes to face-to-face engagement with managers. Finally, transparency is critical. Ongoing provision of data should be the ticket to entry. To borrow from Spider-Man's uncle, with great power must also come great responsibility, and overseeing trillion of dollars definitely qualifies as “great power”. Let’s never lose sight of that and strive to protect all investors in our industry.
This article was originally published on Morningstar Australia and has been adapted.
