Trust, But Verify

February 7, 2023
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Several years ago, my mother handed me a letter. It was a sympathy note written in 1995 by Peter Madoff, expressing condolences on the passing of my father. Peter and my dad served on the Board of Governors of the NASD — the membership-led organization that ultimately created NASDAQ, the largest electronic stock exchange in the world where many of the world’s largest companies, are traded, including Microsoft, Amazon and Google. Alongside a slew of Wall Street titans, my dad had been elected by the membership to represent the industry’s “small firms” and got to know Peter. Peter was polite and charming; he was also Chief Compliance Officer of the family firm, Madoff Securities, and a co-conspirator with his brother, Bernie, in the world’s greatest Ponzi scheme.


Bernie Madoff was born in Brooklyn, New York, in 1938, to Ralph and Sylvia Madoff. His father worked as a plumber before entering the financial industry with his wife. They founded Gibraltar Securities, which was ultimately forced to close by the SEC. Their son, Bernie, dropped out of law school and started off as a penny stockbroker, trading stocks quoted in the “pink sheets” that weren’t listed on any exchange. These thinly traded securities had wide spreads, such that Madoff was able to quickly build his fortune. Success ultimately came when he and his brother, Peter, began building electronic trading capabilities — "artificial intelligence" in Madoff's words — that attracted massive order flow and boosted the business by providing insights into market activity. Essentially, he commoditized all the off-exchange market makers in to one computer screen and legitimized NASDAQ. In its heyday, the Madoff firm was generating 5-7% of the average daily volume of the New York Stock Exchange, making in the vicinity of $100 million a year.  

Along the way, Madoff created a pooled investment vehicle and began managing money for friends and family, promising steady, reliable returns. Soon, he was managing $6 billion - $7 billion without registering as an investment adviser with the SEC. He created a front of respectability and generosity, wooing investors through his charitable work. His business spread like wildfire. 

There is no “Free Lunch”

Since my dad knew Peter from their service together on the NASD Board of Governors, representatives from Madoff came calling on Balentine & Company in the early 1990s. Not unlike other investment professionals, we were struck by the steady, consistent returns Madoff generated, earning a reliable 1% per month. They claimed their “split strike bull spread conversion strategy,” (whatever that means) enabled them to ride the market up and to establish a floor to prevent losses on the way down, making for consistent returns. Every trade was profitable; and yet, there was no plausible explanation for how they did it. Madoff refused to allow us any due diligence, no access to books and records, no willingness to explain their methodology — which was mathematically impossible. Madoff billed its strategy as 100% safe – they hadn’t had a loss in over 20 years and billed their trades as “riskless“ transactions. 96.4% of the months were positive; its returns mirrored the stock market only 6% of the time. The returns were seductively smooth. In fact, Madoff never invested any money; it was a classic Ponzi scheme and ultimately cost investors $65 billion.

There is a tradeoff between risk and return. The only riskless investment I know is a three-month U.S. Treasury bill and yet, keeping all one’s money in T-bills on an after-tax basis has failed to keep up with inflation over time. Equity investors earn a premium over T-bills because we’re willing to stomach volatility, which allows us to earn a return in excess of the risk-free rate.

Do your homework

The American humorist Will Rogers famously said: “We should be more concerned about the return of our money than on our money” and truer words were never spoken. Madoff never registered with the SEC, he never provided online access to clients, his returns were never audited, and his methodology was a black box. There was never any transparency or insight as to how he did it. Paper statements were provided on a dot matrix printer. Not unlike FTX founder, Sam Bankman-Fried, the Madoff saga is not a new story.

At the end of the day, ours is a trust business. But as Ronald Regan said, quoting an old Russian proverb, “Trust, but verify.”

  • Take steps to protect yourself by asking questions and doing your homework
  • Ensure your advisor is registered with the SEC
  • Verify there is a separate custodian holding your assets
  • Ensure they have an audited track record and are in compliance with the CFA Institute’s Global Investment Performance Standards (“GIPS”)

Perfect timing simply doesn’t exist. And if something sounds too good to be true, it probably is.

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