Market Commentary

Lessons from the Madoff Theft

December 2008

"Every great crisis reveals the excessive speculations of many houses which no one before suspected." - Walter Bagehot

Never assume the obvious is true." - William Safire

We write in the wake of a financial fraud of staggering proportions. Bernard Madoff undertook systematic stealing from some of the nation's savvier investors for what looks like decades, and to the tune of 50 billion dollars. All around the world now, and somewhat typically in a sharp downturn, a system that runs in large part on trust and confidence in each other and in the people who handle your money has been undermined. John Kenneth Galbraith, the noted economist of the early 20th century, wrote about how "in good times, people are relaxed, trusting, and money is plentiful," and in bad times, "all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is tremendously improved."

We'd like to address directly some concerns we've been hearing from clients this week in the wake of the news about the Madoff thefts. There are important lessons here about openness, transparency, affordability and simplicity – issues that are a core part of all investment decisions we make for you.

First and foremost, your liquid assets have been nowhere near Bernard Madoff's operation. Your assets are in custody predominantly at National Financial Services, a division of Fidelity Investments, and only we and you have the authority to transact in your investment accounts there. In addition, most of you also have assets in custody at Mairs & Power where your investment in their Growth Fund is held, and only you have authority to transact in those accounts. That's it.

Openness. Madoff ran a secretive operation in which staff and clients had very little knowledge about how exactly he transacted in his business. The reality that they all put up with this degree of secrecy is in fact part of what enabled the stealing. We like to be direct and open with you about everything having to do with your money. We feel there are no secrets here, and invite you to ask all the questions you need to get comfortable about how we handle your money. There is no such thing as a stupid question when it comes to you getting comfortable with how your money is handled.

Transparency. Madoff didn't run a transparent set of investments. He had an investment strategy that wasn't quite explainable, nor could it be documented to people who were expert investors. But, returns were high, and so satisfied investors who were beating the market in all market environments – up and down markets both - looked the other way. Now, we are both researchers by training and also by aptitude. We aren't attracted to things we can't explain, in fact, quite the reverse is true. We are very direct with you in that the strategy we pursue for you attempts to beat the market in a bad environment, which has been the case this year, while lagging the market in a good environment – overall giving you a smoother ride as well as aiming to keep pace with the market over time. This is easily explainable, can be documented with a high degree of transparent detail, and makes common sense to us and to our clients.

In addition, the mutual funds we use, as opposed to the hedge fund that Madoff ran as well as other hedge funds, all have independent boards of directors, must disclose their holdings regularly to securities regulators, and have management teams that are candid and open with us, other advisors, and shareholders about what strategy they are pursuing and able to document the strategy and also explain in plain English how they do it. There are also times that we recommend private investments for clients. We only do so after detailed due diligence and a clear-eyed assessment of both risks and benefits. We are careful researchers, and in the end only choose investments we can understand and can easily explain to you.

Affordability. Another thing that the Madoff scandal teaches us is something Sue has been saying for a long time – that hedge funds are marvelous compensation schemes for the people who work there. With an emphasis on high paychecks that reward short-term performance, hedge funds have made pure short-term capital allocation one of the most handsomely paid professions around. Conversely, our planning and investing for you can bring you much greater value, and includes a long-term orientation for your investment returns that also has us rolling up our sleeves with you on some of your most important life decisions as they will so often have a significant financial impact to you.

Simplicity. Over the years we have had a number of requests to consider hedge fund investments for our clients. The cachet of holding these elite investments has at times appeared attractive to certain of our clients and prospective clients. We have uniformly resisted this call to a less regulated, more expensive, and harder to research set of investment pools. To us, the handful of plain vanilla mutual funds that have produced excellent track records of long-term returns using a consistent discipline with integrity, have been and still are the way to go.

Lately, the fund managers in your investments have been making moves in your portfolio which make a lot of sense to us given the current environment. Your bond funds predominantly remain in high quality and shorter-term debt, but those managers are also looking at selective opportunities in higher yielding debt which they are very good at assessing. Fairholme, First Eagle, International Value Advisers, and Third Avenue Real Estate Value are all active in investing in the corporate bond market, which looks more likely to them to produce better returns than stocks in the intermediate term. Some of these bonds are so deeply discounted by the dislocations in the credit markets, that they expect stock market-like returns from many of these bond issues. And, First Eagle and International Value Advisers continue to sit on substantial sums of cash and also some gold, which provides some overall ballast to your portfolios. All in all, we expect continued economic weakness and bad news, and continued stock market volatility, both up and down. Overall, your portfolios are invested actively in ways that make sense to us and that we think are explainable to you.

Although it's been a difficult year for you with regard to your investments, we want to build your investment performance with openness, transparency, affordability and simplicity in both the good times we've been through and in the bad times we are now in. David Starr Jordan, the first president of Stanford University, noted that something of value was built 'quietly, steadfastly, brick by brick, one step at a time.' It's a tough time. But, we are still at it here for you, building brick by brick.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.