As we take in the 150-year prison sentence of disgraced financier Bernie Madoff, many questions remain regarding the up-to-$65 billion Ponzi scheme he masterminded. For investors, however, the episode raises one question that supersedes all others: How do I avoid investing my money with a fraudster?
Evaluating a proposition
For example, imagine that a friend of yours tells you that he has money invested with a bright young money manager who is doing very well for him. He suggests you consider putting some money with this fledgling star. Intrigued, you make some inquiries and you're able to glean the following information:
him to take their money.These look like red flags, and you decide to pass on investing; you're pleased with your instincts: You may have just avoided being a victim of the next Bernie Madoff. Perhaps.
Welcome to Omaha, circa 1960
Now imagine that the setting is Omaha, Neb., in 1960. Congratulations -- you’ve just passed on the opportunity to invest with Warren Buffett near the beginning of his extraordinary investing career.
Today, it's difficult to think of two financiers who are more dissimilar than Buffett and Madoff. The CEO of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is a model of impeccable business ethics; Madoff, on the other hand, has admitted to perpetrating a multibillion-dollar Ponzi scheme.
However, Buffett told his biographer, Alice Schroeder, that when he was starting out, some people in Omaha thought that he "was doing some sort of Ponzi scheme." So, how does one tell the difference between a Buffett and a Madoff?
Understand where your returns are coming from
Investment strategies fall under broad categories: value investing, momentum "investing," arbitrage, etc. Within a specific category, investment managers may implement a strategy in different ways, but their returns will share certain broad characteristics because they are partly driven by the same underlying factors. In the case of Madoff's "split-strike conversion" strategy, which he applied to stocks in the S&P 100, two of the main factors that drive returns are stock returns and stock market volatility.
[The S&P 100 is a large-cap index that includes blue-chip names such as General Electric (NYSE: GE), JPMorgan Chase (NYSE: JPM), Halliburton (NYSE: HAL), Pfizer (NYSE: PFE), and Ford (NYSE: F).]
Smooth returns year-in, year-out
Once you know this, it is absolutely inconceivable that this strategy would produce extraordinarily consistent returns of approximately 1% a month over several decades, a period during which equity market returns and volatility moved about in a wide range (for reference, monthly returns on the S&P 100 between September 1982 and December 2008 varied between -21.3% and +13.8%).
There is no free lunch with this relatively mechanical strategy: Stock market risk is hedged through the use of options, so only greed or fantasy can motivate someone to believe that it could durably produce returns that exceed those of the overall market.
"Value" isn't riskless
The early Buffett, on the other hand, followed a value strategy, which included investing in special situations (workouts, spinoffs, etc.). This strategy isn't riskless -- it's exposed to market risk, that is, the vacillations of the overall market. Consequently, while Buffett was able to outperform the Dow Jones Industrial Average (DJIA) between 1957 and 1969, his annual returns over that period were highly correlated with those of the Dow (for the statistically-minded, the correlation coefficient was above 0.67).
How does this relate to you? Let's imagine that you want to invest in a small-cap stock fund. One of the funds you are considering promotes itself as such. If its historical returns don't look anything like those of the Russell 2000 Index -- which tracks the small-cap segment -- you should be leery of the fund's stated investment goal. Continued... |