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Harry Markopolos: How to Spot a Fraud

It’s easy. It’s like whack-a-mole. Focus on the manager or the company that is head and shoulders above the rest. Whenever somebody has outstanding performance, Wall Street assumes genius. I assume fraud until genius is proven. Look for the outperformance and investigate there. Compare a money manager’s record vs. others using a similar strategy, or a company’s record against others in the same asset class. If the numbers are too good to be true, they rarely are. A decade ago, there was one energy company head and shoulders above all the others. That was Enron. There was also an insurance company above the rest. That was American International Group. In telecommunications, there was one company above all others. That was WorldCom. They were all accounting frauds.

Today we have one company above all others in technology. That would be Apple. But there’s a visible reason for that, so Apple’s not a fraud. Bernie Madoff said his performance was roughly seven and half times better than the stock index he pretended to be benchmarking himself against. If you’re seven times better, two things can be true: One, you’re a fraud. Or two, you’re an alien from outer space and have perfect foreknowledge of the capital markets.

Bernie’s performance line also went up at a 45-degree angle. In finance, there’s no such thing. If you see a 45-degree angle, either you’re in the middle of a speculative bubble and it’s going to end badly, or fraud is present. There are some simple checks. Do litigation and background searches. If you see arrests or civil lawsuits, access those. It will all be laid out in the legal complaint. Talk to former employees; find out why they left. Ask them about fraud. If they say “I’d love to talk to you, but I signed a nondisclosure agreement,” there’s something bad underneath the surface. Likewise, if your money manager refuses to answer questions, or gives you overly complex answers, assume deception. If you don’t understand the strategy, even after a manager explains it, don’t assume you’re stupid; assume your manager is trying to pull one over on you. Anyone who truly understands their craft should be able to explain their strategy in layman’s terms on a single sheet of paper. If they can’t, you shouldn’t invest.

Markopolos, a financial analyst, alerted the SEC to Madoff's scheme in 2000, eight years before Madoff's arrest.

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