For as long as there have been markets, there have been charlatans, con-artists, and fraudsters getting rich selling hope to the uninformed. In every case, the returns turned out to be “too good to be true.”
Charles Ponzi is probably the most infamous. He wasn’t the first to do it, but they named the scam after him anyway. He defrauded clients with promises of 50% returns in a month and a half or 100% in three months investing in postal stamps.
Of course, there was no investing going on. The only strategy Ponzi followed was to rob Peter to pay Paul. He used money from new clients to pay old clients. As long as he maintained a big enough supply of new clients, he could keep the fraud running. Ponzi’s scheme latest about three years before it finally fell apart.
So right away, there are things to watch out for from Ponzi’s scheme. The returns are unbelievably high and the claimed method of earning them is complex.
Now, Ponzi pails in comparison to Bernie Madoff. Historic market crashes tend to expose fraud going on right under our noses. The 2008 financial crisis was no exception. Multiple cases came to light but Madoff’s was the biggest.
In court filings, Madoff claimed he started his Ponzi scheme in 1991. He promised clients a 20% annual return using a complex split strike price strategy. It involved buying a stock along with selling a call option and buying a put option on the stock. I’m sure Madoff and his team dressed it up wonderfully when they explained it. And he did it all, not by charging high hedge funds fees but a small commission on the volume of trades he placed for his clients.
The thing is when other’s tried to replicate Madoff’s strategy, the results were less than promising. Either Madoff was doing something else behind the scenes or he was lying.
In 1991, Ed Thorp consulted for an investment committee to review their hedge fund investments. In the end, he approved all but one. Bernie Madoff Investments made no sense. Thorp’s clients received monthly updates showing 1% to 2% returns, like clockwork, every month for two years. By Thorp’s estimates, the strategy was producing too smooth returns compared to the monthly swings in the market.
Thorp would go on to analyze every trade confirmation his client’s received from Madoff.
After analyzing about 160 individual options trades, we found that for half of them no trades occurred on the exchange where Madoff said that they supposedly took place. For many of the remaining options transactions, we found that the volume of trades reported for the client’s two accounts alone exceeded the total volume reported by the exchange. To check some of the remaining trades, those which did not contradict the prices and volumes reported by the exchanges, I asked an institutional broker friend at Bear Stearns to find out in confidence for me who all the buyers and sellers were. We could not connect any of them to Madoff’s firm.
In the end, Thorp’s clients withdrew their money and avoided potential disaster. Thorp eventually contacted other Madoff investors who had receipts showing steady 20% gains going back to 1979 and was told it likely went back a decade further. In total, the fraud was estimated in the neighborhood of $64 billion!
A number of red flags popped up for Thorp before he dug into the fictional trades.
First, Thorp was refused a visit at Madoff’s office to see the operation. In fact, there was secrecy around everything. Every investor Thorp talked to was sworn to secrecy. They were told not to tell anyone, at the threat of being dropped. When he asked about the firm auditing Madoff’s books, it turned out to be a single person — Madoff’s neighbor of over 40 years.
Then there were the fees. Many of Madoff’s clients came from middlemen who “verified” and recommended the strategy to their clients — attached with a fat fee for the advice. Why Madoff settled for trading commissions while others collected big fees made no sense at the time.
Finally, like Ponzi’s scheme, the returns were too good to be true. A number of great investors have produced 20% annual returns or more over their careers. So 20% may be hard to believe but it’s not impossible.
But Madoff’s returns were so consistent month to month that it was beyond extraordinary. Equity strategies are the opposite of steady. Volatility rules. The returns of those great investors are best described as lumpy.
Unfortunately, steady and consistent best describes the type of returns most people really want. High returns will always look attractive. The smooth consistency seals it because it suggests little to no risk is involved.
The SEC failed on its end too. It received multiple reports of fraud starting in the early 1990s. In fact, all the reports led to a single, shoddy investigation. Madoff was quickly cleared and further investigations were stopped. In 2008, when Madoff turned himself in, the SEC had no idea as to the level of his fraud.
I’d encourage you to read Thorp’s entire piece, linked below. He goes into greater detail into his experience and includes a few other run-ins he had with fraud.
- Dunning-Kruger Effect: Ignorance and Overconfidence Affect Intuitive Thinking – Debrief
- The Most Important Rule in Investing – Compound Advisors
- A Few Short Stories – M. Housel
- Those Reindeer are Good Investors – Klement on Investing
- How People Get Rich Now – P. Graham
- Li Lu: Value Investing in China – Latticework Investing
- Howard Marks: The Korea Economic Daily Global Edition (video) – Oaktree Capital
- Market Expected Return on Investment (pdf) – M. Mauboussin
- Inside the Dirty Business of Hit Songwriting – Variety