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Posted: April 30, 2009

Madoffs and Merrimans abound

Ultimately, every investment strategy fails, but how many advisors will resort to Ponzi schemes to cover their tracks?

Stephen Mauzy

I cannot pretend to understand the motives of Bernie Madoff and his epigone – Nicholas Cosmos and our own Shawn Merriman. Did they set out to practice what they preached – to provide reliable investment returns regardless of market mien – Quixotically believing they were so devined to actually make it happen? Or are they sociopaths, not the least bit deterred by the eventual suffering of their victims or by the prospect of an onerous fate? (Remember Will Hoover? The former Denver-based financial adviser/Ponzi schemer was convicted of 44 counts of theft, securities fraud and racketeering and sentenced to 100 years in jail, in 2005.)

I'm sure a percentage of advisors, equal to a percentage of the general population, are reprobates – scheming from the outset to abscond with as much money as possible with the intent of retiring to one of those sunny environs that turns a blind eye toward shady people.

Most, I believe, never start down the path to infamy. Those who find themselves managing a pyramid scheme are simply frustrated and nonplussed by their predicament, having started with the best of intentions: to supply the market with that elusive unicorn – the persistent, unfailing return. But when their intentions fail, they try either to save face or to forestall the inevitable.

We're familiar with the approbations Bernie Madoff garnered for dreaming and seemingly reaching the impossible dream – Mr. Automatic and the Jewish bond, two appellations I'm sure he relished. Consistency was the siren song, accompanied by a symphony of elitism – I have something you don't. (Funny how few of Mr. Madoff's victims were lamenting lack of transparency before the run ended.) The Madoff funds attracted investors with the promise of constantly high returns and low fees. His Fairfield Sentry fund, reported $7.3 billion in assets and claimed to have paid more than 11 percent interest each year through its 15-year track record. It was a mirage, of course, but one that lured the world's brightest lawyers, businessman, financiers and entertainers to its irresistible waters.

At the other end of the oasis, Nicholas Cosmos proved the thirst for investing equanimity was equally insatiable among the proletariat. Why else was he able to accumulate $380 million from a trusting amalgam of blue-collar workers and civil servants, despite the fact he was sentenced to 21 months in prison, in 1999, and ordered to pay restitution of $177,000 plus interest and to undergo therapy for gambling?

Mr. Cosmos' scheme was crude, if not obvious to even moderately sophisticated investors. According to the federal complaint, he allegedly set out to provide short-term loans to businesses. The loans were to be secured by borrowers’ assets, with returns as high as 48 percent to 80 percent per year.

And Mr. Merriman? He appears to be a pennyante admixture of Bernie Madoff and Nick Leeson, the Baring's Bank trader who kept doubling down until he finally broke the bank, in 1995. Mr. Merriman wanted to deliver Madoff-like returns, but he was cursed with Mr. Leeson's flair for losing money.

I run into at least one claim – often two or three – of unfettered, linearly generated riches at the popular advisor gathering spots – golf courses, broker/dealer conferences, forecast dinners, affinity group luncheons. Even while vacationing in Mazatlan, Mexico, I was unable to avoid their braggadocio.

Richard (last name withheld), a Brooklyn-based stockbroker I met at an al fresco cafe during morning coffee, regaled me with his strategy of buying puts and selling calls around a basket of broad-market ETFs (though he would not reveal which ETFs) that enabled him to lock in a 10 percent return last year, marking the fifth consecutive year he had returned at least 10 percent to his clients. When I countered that his strategy sounded eerily similar to Bernie Madoff's, he brushed aside my protestation with a breezy, irony-free response: “Okay, maybe it was a little less than 10 percent, maybe more, but my strategy will always allow me to avoid the downside while generating a double-digit return for my clients.”

Richard's strategy, like Madoff's, is the one most often employed to capture the elusive, but much-desired, consistent rate of return and is the one that should immediately raise investor skepticism. An advisor will claim his strategy is immune to market vagaries because it consists of buying puts and selling calls around a stock index or basket of stocks. It seems plausible because downside is limited, but so is upside. To goose returns, the advisor overlays his proprietary strategy, usually based on some quirky technical analysis algorithm or a new predictive model like generalized autoregressive conditional heteroskedasticity, GARCH in statistical patois – recondite stuff that simultaneously impresses and confuses. The overlay improves the advisor's soothsaying skills; thus, alchemy is achieved.

It's all so persuasive (even to a CFA charter holder and 20-year investing veteran like me). For one, we want to believe the advisor is special. If he is special, therefore we are special, so the juxtaposition to a Bernie Madoff fails to register. What's more, the intimacy of the contact – a country club bar, a golf course, a small dinner gathering – coupled with the advisor's conviction and sincerity, further disarm. The danger of possible financial ruin seems less real, if it seems real at all.

Ultimately, every investment strategy fails, but many advisors refuse to acknowledge that truth. I am unsure how many of these putative market-beating geniuses will resort to Ponzi schemes to cover their tracks or to buy time to recapture past glory when reality hits, but I can assure you, through firsthand experience with the egos involved, Shawn Merriman isn't the last, as we will no doubt discover in coming months.

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Stephen Mauzy is a CFA charterholder, a financial writer and principal of S.P. Mauzy & Associates. He can be reached at

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