Some Basics to Help Keep Would-Be Madoffs at Bay

As investors deal with the challenges of a bear market—already a tall order—they must also be on guard against another threat. This one comes from their fellow humans, unfortunately. While fraudsters are always active, many of their plots come to light and make headlines during bear markets—like Bernie Madoff’s famous 2008 Ponzi scheme, which emerged only after the big bear market led many of his clients to seek withdrawals. But sharp volatility can also sow the seeds of future schemes, as many investors’ frazzled nerves have them clamoring for “safe” investments with good returns and no downside. With that in mind, we think it is worth remembering how these plots generally look—and how you can protect yourself.

Stocks’ historic March plunge has roiled many investors’ portfolios—and their emotions along with it. After global stocks entered a bear market in three weeks, many probably feel the pull of something “safe” and steady—a way to earn equity-like returns with less, or no, downside risk. Yet this is a fantasy. No financial product can provide returns approaching stocks’ without risk, in our view. Yes, some salespeople claim products like indexed annuities, for example, deliver that. But their returns are usually far from equity-like over meaningful time periods, undercutting the claim.

Setting those legal-if-suboptimal (in our view) tools aside, many scammers use similar rhetoric to pitch fancy strategies and tactics featuring relatively high upside and, critically, no downside. Consider: Since 1985, the MSCI World’s average annualized return is 8.4%.^[i] A fraudster may say their product delivers a return that is a shade under that average, but, temptingly, without any of the associated negative volatility. Or perhaps they claim their strategy combines a proprietary process with “alternative investments” nobody else is using—allowing them to remove the downside risk. Madoff’s “split/strike conversion” strategy, for example, involved buying and selling options on a portfolio’s stock holdings—and drove high and consistently positive returns. Illuminatingly, nobody could replicate his results, which is probably because they weren’t possible.   

As the old saw goes, if it sounds too good to be true, it likely is. Equities have the highest long-term returns of any similarly liquid asset class, but the price tag for those returns is volatility risk. A look back at the past 34 years for the MSCI World illustrates how returns fluctuate on a year-to-year basis.

Exhibit 1: MSCI World Annual Returns, 1986 – 2019

Source: FactSet, as of 3/30/2020. MSCI World Index annual returns with net dividends, 12/31/1985 – 12/31/2019.

Even during bull markets, annual returns may be “below average” or negative periodically, as in 2011, 2015 and 2018. Moreover, significant volatility or price swings happen during the best years, too. If someone is pitching you a strategy offering returns anywhere near stocks’ with little to no downside risk, we think you should be extremely skeptical. Other major asset classes with less volatility typically have lower longer-term returns—and even they feature occasional negatives. Long-term US Treasurys’ annualized total return since 1985 is 6.6%—trailing global stocks over the same period.^[ii] Treasurys also posted five annual declines since then (1987, 1994, 1999, 2009 and 2013).^[iii] Well-known commodities (i.e., gold) are no less volatile than stocks and average lower long-term returns.

If confronted with a seemingly appealing offer, here are some important things to look for. First, seek out the bad years. Are returns eerily consistent and only positive? That should raise some eyebrows. Even the best managers will have some poor years, whether due to the environment (e.g., a bear market) or a portfolio decision that didn’t work out. If they don’t have any bad stretches, press them to explain why. How did they generate those remarkably smooth, positive returns during times when most markets were down?

Second, ask them to explain their strategy in simple, plain language. An inability to explain financial jargon is another red flag. At worst, it is an attempt to obfuscate and confuse; at best, it reveals ignorance—not a great trait, either.

Other due diligence is critical, too. A hallmark of bad actors, at least in America: They seek custody of your assets and pool them with other clients’ money rather than house them at an unaffiliated third-party custodian (i.e., brokerage house) in an account with your name on it. A custodian provides regular statements and online access, allowing you to monitor your account at your discretion. They also give you a check-and-balance over potential misbehavior. The lack of visibility and third-party involvement have been key to many major historical wrongdoers’ plans—including Madoff’s and “Sir” Allen Stanford’s.

Another consideration to be mindful of: Many fraudsters exploit their personal networks and communities, effectively using “affinity marketing” to find targets. In these cases, the bad actor runs in the same circles as you, a friend or a family member. Maybe they attend your religious congregation. Or perhaps they belong to the same community group or ethnic organization or share some other common association that provides an easy path to build trust. Access and personal connection can build a false sense of security. For example, Madoff used his high-profile status in the Jewish community to take advantage of investors. There are scads of similar, if small-scale, plots uncovered every year that hinge on these kinds of relationships. Just because someone’s office is a 10-minute drive from your house or you see them every week at Sunday services doesn’t mean you shouldn’t do rigorous due diligence on any plan they are presenting you.

We understand the appeal of something that seems “safe” during sharp, painful volatility. But without doing proper due diligence, you risk losses of a different kind—ones that could be permanent.