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Due negligence: failing to do the analysis
Of course, no one wants to take undue career risk by sticking their head up and saying the emperor isn’t wearing any clothes but ...
Harry Markopolos, Madoff’s whistleblower
These days investors are swamped with information about markets, industries and companies. Even if you spent your whole life ploughing through the material, you could never master it all. Realising this, many investors simply give up, and make arbitrary, often inconsistent, investment decisions or rely on the assurances of the organisations involved in selling them investments. But how can an investor happily accept statements made by any financial services company at face value in a time when we know that so many of them are incentivised to put their own interests above those of their customers? Investors really do need to make an effort to perform as much due diligence as possible; in essence, due diligence means independently verifying all the key elements of the investment on offer, and considering all the possible risks.
Let’s see how a private investor’s due diligence can work in practice. I have been looking at the services offered by a firm that provides an online portfolio management service (let’s call it ‘Firm X’). The investments are restricted to Exchange Traded Funds (ETFs), which are a relatively new kind of collective investment that are marketed as a transparent, straightforward investment vehicle with low management charges, and are growing in popularity. I knew something about ETFs, but had never put any time into trying to understand what they really are and how they really work. Now that Firm X had caught my attention – mainly through its emphasis on the ease of use, low charges, and the facility to monitor your investments closely – I felt I had to learn more. And that’s where due diligence begins: first of all, you do really need to understand the investment you are being offered. Firm X’s website is helpful and informative, but it definitely does not tell you everything you need to know. Although its initial advertising (which I noticed on the London Underground) didn’t say so, Firm X’s website explained, not very prominently, that it only offers a discretionary service, which means you tell them roughly what your investment aims are and they decide what ETFs to buy and sell on your behalf. There is nothing wrong necessarily with a discretionary service, but it does take away some decision-making power from the investor, so that feature immediately went down in my notebook as something to think about further. I also felt slightly uncomfortable that it seemed quite possible for an ordinary person (the ad on the London Underground depicted a girl in her twenties happily managing her portfolio on her laptop) to invest without really understanding all the implications and risks. This is not to suggest Firm X is anything other than a respectable firm, but it alerted me to the fact that the sales pitch was a bit too consumer-orientated for my taste; yes, I want things to be easy, but I don’t want to be patronised.
Then I started to read up on ETFs. I quickly discovered that they are controversial. An article in the Financial Times quoted a fund manager who is ‘a fierce critic of ETFs’ as saying, ‘there is a certainty that ETFs are being missold to the retail market and that the risks being incurred in running, constructing, trading and holding them are not sufficiently understood.’ A fact sheet from the FSA talks about the risks of Exchange Traded Products (ETPs) and explains, although most ETPs are funds (i.e. ETFs), some are structured as debt securities – so that point goes down in my notebook as something to check, since I had already noticed Firm X’s website mentioned investing in commodities, which the FSA gives as an example of a debt security ETP. Then I notice that Kweku Adoboli, a UBS trader who lost the bank $2.3 billion in unauthorised trading and was convicted of fraud in 2012, had been trading ETFs – definitely another point on my list of things to investigate further. I start reading endless articles debating whether or not ETFs and ETPs are a good thing. I noted that HSBC ‘only offers physical ETFs on the basis that individual investors have a better chance of understanding them’, and there are also ‘synthetic ETFs’, which invest in ‘bespoke derivatives, or swaps, to deliver the performance of the relevant index or stockmarket.’ I am pretty sure I don’t want my money going into synthetic ETFs, so that’s one more thing to check with Firm X.
After a few hours’ reading, I have had enough, and decide to exercise the one fantastic right that private investors have and so many finance professionals don’t: I decide to defer my decision. Maybe I’ll come back to it later, and maybe I won’t; I don’t have anyone breathing down my neck asking why I haven’t done anything, the way finance professionals do, and I don’t have to justify my decision to anyone. I have decided not to decide, and I feel great!
From what I have learned so far, ETFs are a lot more complicated than they first appeared, and I particularly don’t like the fact that some index-tracking ETFs track an index that has been custom-made for that ETF – as the FSA points out, ‘if the institution that creates the index is affiliated to the ETP provider, it may have an incentive to select the individual constituents of the index to optimise its own revenues, rather than that of the investor’. This particular FSA document is intended for investment advisers and contains a lot of juicy technical questions on a wide range of risk issues. These questions can go on my due diligence list should I ever decide to investigate further.
Most of the due diligence that you do should result in a ‘no’ or ‘do nothing’ decision fairly early in the process, so it is less work than it may appear at first. You only have to turn into a terrier burrowing for rabbits if what you are finding looks good and you want to invest. Yes, this kind of due diligence takes some time and effort, but you haven’t had to pay for any fancy lawyers or analysts to do the work for you, so the cost is low. If you are the kind of person who can’t or won’t do this kind of analysis you probably won’t be reading this book anyway, but if you are analytically inclined, you might reasonably complain that it is all too much work, and you would much rather find someone you trust to do all the heavy lifting for you. And that was what Bernie Madoff offered.
As the process described above has illustrated, there are clearly many limitations to the amount of due diligence that a private investor can do. Unless you happen to be a very specialised investment lawyer, for example, you probably won’t have the skills to understand all the legal issues involved. And unless you knew a lot about options, you probably could not have understood completely the ‘split-strike conversion strategy’ that Madoff falsely claimed to be using to generate his steady returns, but the beauty of a healthy and vigorous financial press is there are people out there writing articles who know more than you do on particular investment issues. There are also a lot of people out there writing articles who know considerably less than you do, but with practice you can learn to weed them out.
The Madoff scandal was a huge surprise when it emerged in 2008, but as we saw earlier (Chapter 3) there had been two sceptical articles about Madoff in the financial press in 2001, one in the MARHedge trade journal entitled ‘Madoff tops charts; skeptics ask how’, and the other in the better-known Barron’s magazine entitled ‘Don’t Ask, Don’t Tell’. You might not have found the MARHedge article by browsing the internet in 2001, but you certainly would have found the Barron’s article. Incidentally, private investors should try to punch above their weight in their choice of investment reading matter – even if you don’t understand everything, it is a good idea to read professional and academic investment articles, and not to confine yourself only to the mainstream media, which tends to dumb things down.
So, let’s consider what a private investor could have gleaned about Madoff’s operation from the two 2001 articles. ‘Don’t Ask, Don’t Tell’ informs us that Madoff is well-known on Wall Street as a top market maker for the NASDAQ stock market, is very active on the New York Stock Exchange, but also it is less well known, he manages more than $6 billion of rich people’s money. So far, so good, but then there is this: ‘What’s more, these private accounts have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.’
Never had a down year? Returns of 15% a year for more than a decade? At the very least, we need to know how he did it. The article gives us a potted description of how Madoff’s split-strike conversion strategy is supposed to work, and then tells us that there is speculation Madoff’s market-making arm subsidises his investment funds to ‘smooth’ the investment returns. If true, this would definitely not be OK, but the article reports Madoff’s firm denial that he does this, and then goes on to quote a number of people who don’t believe it is possible to achieve such good returns from a split-strike conversion strategy. Madoff naturally says they are wrong. It then goes on to discuss Madoff’s secrecy, citing an investment manager who withdrew money from Madoff, saying, ‘when he couldn’t explain how they were up or down in a particular month ... I pulled the money out’. So, we can’t find out how he does it. That alone deserves a big bold point on your due diligence list. It might not have been enough to stop you investing, but it certainly should have been enough to prevent you from putting all your life savings into Madoff, as some of his victims are alleged to have done.
Let’s suppose that you also obtained the MARHedge article. It’s longer and more technical, but the central message is perfectly clear: many investment professionals cannot understand how Madoff has achieved good, steady returns for 11 years using a split-strike conversion strategy, because normally you would expect more volatility (ups and downs) in the returns. Note that neither article even whispers the word ‘fraud’ – in general, the responsible end of the financial press will never cry ‘fraud’ until someone has been arrested. Nevertheless, the MARHedge article identified the key due diligence issue, namely that no one could figure out how Bernie did it. That would have been enough for me to walk away; personally, I never want to invest in a mystery, even if it means I might lose out on some juicy profits. It reminds me too much of the company that invited investment ‘for carrying on an undertaking of great advantage but no one to know what it is’ during the South Sea Bubble of 1720 (the promoter of that one absconded with all the money).
Harry Markopolos and Bernie Madoff
Harry Markopolos is an unprepossessing, nerdy fellow who also happens to be a maths whizz and a Chartered Financial Analyst. In a 2005 letter to the SEC he described himself as a derivatives expert with ‘experience managing split-strike conversion products both using index options and individual stock options both with and without index puts. Very few people in the world have the mathematical background needed to manage these types of products but I am one of them’.
As mentioned earlier (Chapter 3), Markopolos repeatedly approached the SEC between 2000 and 2008 with plausible evidence that there was something wrong with Madoff’s investment operation. At the time he began this crusade, Markopolos was working at a small options trading firm in Boston. His firm was a competitor to Madoff in a small way, and Markopolos was asked by his boss in 1999 to see if he could construct a split-strike conversion strategy similar to the one Madoff was supposed to be using, with a view to attracting some custom for his own firm. In a TV interview Markopolos gave in 2011, he claimed that when he first examined some Madoff data, ‘in five minutes I knew, I said this is totally bogus’. The document he had examined was a one-page marketing aid from the Broyhill All-Weather Fund (one of the feeder funds that invested in Madoff) that described Madoff’s investment strategy and stated the monthly returns between 1993 and March 2000.
So let’s see the kinds of things that an expert (Markopolos) was able to figure out by studying Madoff’s operation from the outside in a few hours of initial analysis. Markopolos says that he suspected fraud so quickly because the strategy, as described in the Broyhill document ‘would have had trouble beating a 0% return.’ He knew this, he says, because he had been managing a ‘slightly similar’ options strategy and knew from experience that it was not possible to have as few loss-making months as Madoff’s figures suggested. He then entered the Broyhill monthly figures in a spreadsheet, noticing that Madoff seemed to be confused about which stock market index he was using as a benchmark, the S&P 500 or the S&P 100 (these two indices perform very differently from one another). Markopolos found that Madoff’s performance had a very low correlation (6%) with the S&P 500 and, more importantly, while Madoff had had only 3 down months out of a total of 87 months, the S&P 500 had been down in 28 months during the same period.
Markopolos then obtained statistical data from the Chicago Board of Trade concerning the number of options being traded for the S&P 100, the index that Madoff’s strategy was explicitly supposed to be replicating (despite Madoff’s constant references to the S&P 500). He found that there were not enough index options in existence for Madoff to have been able to have run his options strategy as described in the Broyhill data. There appeared to be two possible explanations of what was going on. The first was that Madoff was illegally ‘front-running’, which is when a broker has a stream of large orders to execute in the market, and profits from this information by trading on his own account minutes in advance of executing his clients’ orders. Performing further mathematical modelling, Markopolos found that front-running Madoff’s portfolio of billions of dollars could indeed have generated extra returns that might account for his stellar performance, assuming he put these illegal profits back into his clients’ funds. Markopolos thought in 2000 and 2001 that this was the most likely explanation, but as Madoff’s funds under management grew in subsequent years, it became evident that front-running could no longer explain Madoff’s continued steady returns. Nevertheless, as we saw earlier (Chapter 3), SEC investigations continued to work on the front-running hypothesis for several years afterwards.
The second possible explanation for Madoff’s returns – which eventually turned out to be correct – was that Madoff wasn’t actually investing at all, and instead was simply making up his monthly returns as part of a massive Ponzi scheme.
So why hadn’t anyone else noticed this problem, given that many large financial institutions had put customers’ money into Madoff in one way or another? In his 2011 TV interview Markopolos argues that these institutions, particularly those in Europe, did think that Madoff was a crook, but they thought he was stealing from clients using his broker–dealer arm to subsidise his funds. According to Markopolos, the institutions did not ask Madoff the questions they could and should have asked because they would have then been implicated if they had continued to send clients to Madoff after discovering any wrongdoing. Why did they want to go on putting clients on to Madoff? Because Madoff paid unusually high fees to institutions that brought him business, says Markopolos, and they didn’t want to lose these fees.
A word on funds and funds of funds
Many of Madoff’s victims who invested through feeder funds, we are told, were unaware that their money had ended up being managed by Madoff. This suggests that there was quite a problem of lack of transparency in these funds, which in itself would be a definite black mark in a due diligence exercise. But another problem with feeder funds and funds of funds (the latter are funds that only invest in other funds) is that they add an extra layer of charges, which in many cases offsets any gains you might have made by investing in them, and, indeed, may substantially reduce your overall return. As we saw earlier (Chapter 6), there is good reason to doubt that fund managers actually bring anything of value to the table, since the majority of them do not outperform the indices used as benchmarks to judge performance. It follows, therefore, that you are likely to obtain a better return in the long term by investing in a true index fund (unfortunately there are now many index funds that do not truly mimic an index) with low, low charges.
Terry Smith is a British analyst who in 1990 published the excellent Accounting for Growth, which exposed the deceitful accounting practices being used by many rapidly growing companies at that time. More recently Smith made an interesting analysis of what would have happened to investors in Warren Buffet’s company, Berkshire Hathaway, if he had run it as a fund with typical hedge fund charges, instead of it being a company in which you and he are fellow shareholders who share the profits. As is well known, Buffett’s long-term performance has been very good, even though it has slowed in recent years, as Buffett predicted, because Berkshire is so big now it is harder to find investments that really make a difference to the annual return. Between 1965 and 2009 a $1,000 initial investment with Buffett would have grown into $4.8 million by the end of the period in nominal terms (to find out what $4.8 million would be in 1965 dollars, you would have to adjust for inflation, but it would still be an excellent return). Smith argues that if ‘Buffett had set it up as a hedge fund and charged 2 per cent of the value of the funds as an annual fee plus 20 per cent of any gains, of that $4.8m, $4.4m would belong to him as manager and only $400,000 would belong to you, the investor. And this is the result you would get if your hedge fund manager had equalled Warren Buffett’s performance. Believe me, he or she won’t.’
For investors, any charges are a bad thing, because they reduce your return. Sometimes they may be unavoidable – you can’t for instance buy and sell shares for free – but fund charges are absolutely avoidable. To avoid them, all you have to do is not invest in the fund! If you invest in an index tracker fund, you will pay charges, but the total expense ratio (TER), which measures the total costs to investors including all fees, can be as low as 0.27%. That’s just over a quarter of 1%, which most people can live with. Yes, index trackers won’t beat the index, and some hot-shot managers do beat the index for a while, but only very few, like the glorious Warren Buffett, have been able to do it spectacularly over many decades. Sadly, it is probably too late to obtain spectacular returns by investing in Berkshire because of its size, and when Buffett finally retires or passes away, it is highly unlikely that any replacement will be able to match his long-term performance.
So here’s another point about due diligence; remember that you, the investor, are investing for your whole life. Funds and fund managers come and go, and there is a clear moral hazard if they are getting rewarded by short-term performance and taking a cut out of your assets every year.
Due diligence always matters
Glib assurances are no substitute for doing your own due diligence as much as possible. If you buy a house, for instance, you would take a lot of trouble to find out everything you could about it yourself, as well as paying experts – lawyers and surveyors – to make further checks that you cannot do properly yourself. Although some people unwisely try to cut corners by, for instance, not paying for a full structural survey, most people understand this is a false economy. Sensible people will also bring along a builder they trust to view the house, to help them understand what any renovations or additions are likely to entail. They will walk around the neighbourhood and talk to local people about it. They will visit the house at different times of the day to get a feeling for things like traffic and noise levels. They will compare prices and research planning issues. In short, people tend to be very, very fussy about buying a house, not only because they don’t want to be sold a pup but also because they really want to understand what they are letting themselves in for. That’s due diligence! Many of these fussy house buyers are much less fussy about choosing financial investments, which makes no sense at all.
Doing due diligence is not just about spotting possible fraud; it is also about making sure that you properly understand what you are investing in. Some kinds of ETFs, for instance, may be right for you, but if you don’t understand how ETFs work, you are leaving yourself open to potentially nasty surprises, quite unnecessarily. So make sure that you really do understand what you are buying. And, to continue the house-buying analogy, you wouldn’t buy a house just because a lawyer or a surveyor told you to, would you? So why would you invest in something just because a financial adviser or a salesperson told you to do so? Now, there are some very wise old advisers and brokers who know what they are talking about, but most of the ones you will encounter are just reasonably well-trained drones. They will follow the regulations and conduct a ‘fact find’ into your circumstances and risk appetite before recommending investments, but those investments may be considerably less bespoke than they seem – and cases of misselling occur with monotonous regularity. So don’t switch off your brain just because you have an adviser!