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:

  • The money manager is secretive, he works alone, and he handles the administrative paperwork of his investment partnerships himself.
  • He's produced market-beating returns consistently, but only reports his performance to his investors once a year.
  • Finally, he does nothing to market his investment partnership -- prospective investors have to ask 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.

Understanding a manager's interests
When you are making a decision to entrust someone with your money, you should try to understand that person's interests and how well they are aligned with your own.

If Madoff's returns were legitimate, why forgo billions of dollars (yes, billions) in performance fees by operating as an investment advisor instead of a hedge fund manager (hedge fund managers charge their investors a percentage -- 20% is fairly standard -- of the returns they earn)?

His excuse -- that he didn't want the hassle of administering a hedge fund -- doesn't pass the laugh test; this was someone who had already built a successful broker-dealer operation from scratch, after all. In effect, Madoff was simply gifting billions in fees to the "feeder funds" who were the ones charging performance fees to their investors instead. Madoff's choice was so irrational that it should have given any informed prospective investor pause.

This massive discrepancy in economic interest is unlikely to exist with most mutual funds or hedge funds, which follow pretty standard arrangements. However, this serves as a broader lesson in analyzing other business opportunities: If you can't understand the interest(s) of the other party, it's a hint that the arrangement they are presenting you with is not what it appears to be.

Look for managers that will invest alongside you
By contrast, Warren Buffett, like present day hedge fund managers, was compensated based on his investors' profits (unlike most hedge fund managers, however, he didn't take an additional fixed percentage of assets to meet operating costs). As such, his interests were aligned with those of his investors -- in fact, he eventually became the largest investor in his partnerships. Today, Buffett remains the largest shareholder of Berkshire Hathaway.

That is a rational arrangement which helps to align the interests of the general partner/CEO with his limited partners/shareholders. Mutual fund groups in which managers are significantly invested alongside their investors include Southeastern Asset Management (Longleaf Funds), Davis Funds, FPA Capital, and Royce Funds.

Learn to ask simple questions
The details of the investment management business can be complex, but the important questions are often straightforward. As with any venture -- business or otherwise -- the better you understand the proposition, the lower your risk. In investing, determining how returns are generated (at least at a high level) and how your partner is compensated are the first steps toward avoiding frauds like Madoff.

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway is a Motley Fool Stock Advisor selection. Berkshire Hathaway and Pfizer are Motley Fool Inside Value selections. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.