Posted by on Dec 16, 2008 in Articles & Advice, Blog, Columns, Featured, Video |

Image Credit: Jan Pietersz. Saenredam, after Hendrick Goltzius, “The Fool” (ca. 1595), The Museum of Fine Arts, Houston 

By Jason Zweig |  Dec. 13, 2008 11:59 p.m. ET

What do George Carlin and Bernard Madoff have in common?

The late comedian immortalized oxymorons, those absurd word pairs like “jumbo shrimp” and “military intelligence.” Mr. Madoff just put the silliest of all financial oxymorons into the spotlight: “sophisticated investor.”

The accounts managed by Bernard L. Madoff Investment Securities LLC reported gains of roughly 1% a month like clockwork, with nary a loss, for two decades. Why did that freakishly smooth return not set off alarms among current and prospective investors?

Of all people, sophisticated investors like Mr. Madoff’s clients should know that if something sounds too good to be true, then it’s not. But they believed it anyway. Why?

Mr. Madoff emphasized secrecy, lending his investment accounts a mysterious allure and sense of exclusivity. The initial marketing often was in the hands of what one source described as “a macher” (the Yiddish term for a big shot). At the country club or another exclusive rendezvous, the macher would brag, “I’ve got my money invested with Madoff and he’s doing really well.” When his listener expressed interest, the macher would reply, “You can’t get in unless you’re invited…but I can probably get you in.”

Robert Cialdini, a psychology professor at Arizona State University and author of Influence: Science and Practice, calls this strategy “a triple-threat combination.” The “murkiness” of a hedge fund, he says, makes investors feel that it is “the inherent domain of people who know more than we do.” This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive his funds were, Mr. Madoff shifted investors’ fears from the risk that they might lose money to the risk they might lose out on making money.

If you did get invited in, then you were anointed a member of this particular club of “sophisticated investors.” Once someone you respect went out of his way to grant you access, says Prof. Cialdini, it would seem almost an “insult” to do any further investigation. Mr. Madoff also was known to throw investors out of his funds for asking too many questions, so no one wanted to rock the boat.

This members-only feeling blinded many buyers of Mr. Madoff’s funds to the numerous red flags fluttering around his operation. When you are in an exclusive private club, you do not go rummaging around in the kitchen to make sure that the health code is being followed.

Here we have the biggest dirty secret of the “sophisticated investor”: Due diligence often goes undone. For a brief window in 2006, the Securities and Exchange Commission required hedge funds to file standardized disclosure forms. William Goetzmann, a finance professor at Yale School of Management, found that hedge funds disclosing legal or regulatory problems and conflicts of interest ended up with lower future performance. But the disclosure of these risks had no impact at all on how much money flowed into the hedge funds.

In other words, investors were getting useful information — and paying no attention to it. Amaranth Advisors LLC, the commodity hedge fund that collapsed in 2006 with $6 billion in losses, did not even file the required SEC form at the beginning of that year, a clear signal that something might be wrong. Instead of standing pat or pulling money out, investors poured more money in.

Last year, the Greenwich Roundtable, a nonprofit that researches alternative investments, conducted a survey of consultants, pension plans, “family offices,” funds of funds and other large investors who shop for hedge funds. It’s hard to imagine a more sophisticated crowd.

Yet one out of five investors in the survey reported that they “always follow” not a formal checklist or analytical procedure, but rather “an informal process” of due diligence.

That’s for sure. One out of four investors surveyed will write a check without having studied the financial statements of the fund. Nearly one in three will not always run a background check on fund managers; 6% may not even read the prospectus before ever committing money.

“Due diligence,” says Stephen McMenamin of the Greenwich Roundtable, “is the art of asking good questions.” It’s also the art of not taking answers on faith.

If you invest with anyone who claims never to lose money, reports amazingly smooth returns, will not explain his strategy, refuses to disclose basic information or discuss potential risks, you’re not sophisticated. You’re an oxymoron.

Source: The Wall Street Journal


Related video: Inside the Madoff Scandal


Correction & Amplification

Amaranth Advisors LLC was exempt from a 2006 requirement to file disclosure forms with the Securities and Exchange Commission. This article incorrectly states that Amaranth was subject to this rule.