Would You Invest With the Best Hedge Fund Manager in the World?

The best hedge fund manager in the world delivered consistent, non-volatile returns month after month over a dozen-year period. Compared with 41 funds in a leading European database, a fund utilizing this manager's strategy ranked as the best performer on a risk-adjusted basis over that time frame. And the success of this proprietary strategy wasn't a result of luck, either. It had been honed on Wall Street for more than 40 years.

Many investors were desperate to invest with this remarkable investment manager back in 2001, especially since his strategy had outperformed its benchmark by 24 percentage points during the previous year. His $6 billion to  $7 billion in assets under management at that time put his firm in the number one or two spot in a Zurich database of more than 1,100 hedge funds, and his reputation for exclusivity made his services all the more desirable to investors. Who wouldn't want to invest with the very best?

Simply unbelievable returns
Unfortunately for all those eager investors, the investing mastermind mentioned above was named Bernard L. Madoff. In a prescient profile of Madoff in 2001 titled "Madoff tops charts; skeptics ask how," Michael Ocrant raised some troubling questions about his too-good-to-be-true investing returns. We now know, of course, that Madoff's uncanny ability to outperform with considerably lower risk was a fantasy. In retrospect, it all seems so painfully obvious.

Ocrant's piece on Madoff, which appeared in the hedge fund industry publication MARHedge, is a remarkable document. After discussing Madoff's strategy and tremendous performance, Ocrant reports that more than a dozen industry professionals questioned the consistency of those returns. Speaking on the condition that they wouldn't be identified, these professionals noted that others who used a similar strategy "had nowhere near the same degree of success." It wasn't so much the returns themselves that were so unusual to these observers. Rather, it was the "ability to provide such smooth returns with so little volatility."

Madoff addressed those doubts in a face-to-face interview and several telephone interviews with Ocrant. He argued that conditions had been favorable for his strategy, and felt that he deserved "some creditability as a trader for 40 years." He also believed that his performance could be attributed to his excellent technology as well as his good proprietary stock and options pricing models. Perhaps believing his own lies, Madoff added that his strategy and trading "are done mostly from a proprietary 'black box' system that allows for human intervention to take into account the 'gut feel' of the firm's professionals."

Madoff's self-defense concluded on a defiant note, however. He said, "I'm not interested in educating the world on our strategy, and I won't get into the nuances of how we manage risk." To the skeptics, he responded cryptically, "The strategy is the strategy and the returns are the returns."

Trusting strangers with our life savings
Despite the questions raised by Ocrant in 2001, Bernie Madoff's Ponzi scheme continued for another excruciating seven years. In a recent settlement between U.S. authorities and JPMorgan Chase (JPM -0.52%), we learned that Madoff Securities by 2008 had more than 4,000 investment advisory clients, which supposedly had a combined balance of around $65 billion. At the time of his arrest, of course, Madoff had only around $300 million in assets. Many investors lost everything as a result.

So, why were investors so trusting of Bernie Madoff? Were the danger signs obvious enough for prudent investors to steer clear of him?

Clearly, there were some warning signs out there, as Ocrant's article demonstrates. And in the years leading up to the arrest, there were quite a few investment analysts and bankers who expressed their skepticism about Madoff's strategy.

On the other hand, there were lots of sound reasons to believe Madoff was probably a safe bet. He had more than 40 years of experience on Wall Street, after all, and had presumably been subjected to the due diligence of some of the most prestigious hedge funds and Wall Street banks around.

For example, Fairfield Greenwich Group -- which operated some of Madoff's largest feeder funds -- assured investors that it maintained "full transparency" into Madoff's accounts and was able to provide "independent verification of prices and account values." Meanwhile, JPMorgan Chase was Madoff's primary banker for more than 20 years and even structured products around his feeder funds. Surely, it must have checked him out thoroughly. Right?

Whom do you trust on Wall Street?
In Diana Henriques' excellent The Wizard of Lies, she wisely points out that the biggest lesson from the Madoff affair is one that no one wants to accept:

We all invest on faith. We all believe that trust is all we need – indeed, most of us don't have enough time or information to rely on anything but trust. If regulators and policymakers don't acknowledge this, their approach to the chronic problem of market fraud will be limited and ineffective.

This is a valuable insight for anyone who hands over their hard-earned money to someone else to manage. None of us -- if we are truly honest with ourselves -- is immune from being the victim of a fraud. Perhaps that's the bitter takeaway from this despicable financial crime.

Of course, we can all take steps to better protect ourselves. Henriques recommends that we read the fine print, and retain a healthy skepticism when it comes to our investment manager's claims. And everyone should be diversified, too, in order to prevent losing everything, in the event of fraud or mismanagement.

A final piece of advice comes from JPMorgan's suspicious activity report on Madoff to U.K. authorities in October 2008. If the investment returns of a fund appear to be too good to be true, they probably are.