Vetting Investment Advisers to Avoid a Madoff

Bernard Madoff's Ponzi scheme lost his investors a cumulative $50 billion. But perhaps one of the most difficult losses to recover won't be the dollars, but the bonds of trust that the legendary money manager has shattered. Investors, financial advisors and charitable foundations placed their faith in Madoff, their futures dependent on his continued steady performance. "If you had an investment with him, you're probably doing a lot of questioning," says Evan Roth, founding partner and director of client services at BBR Partners, a boutique wealth-management firm in New York City. "Some investors have learned the hard lessons about what due diligence means and who they have as their advisor." (BBR Partners, after performing preliminary due diligence which raised significant red flags, opted not to recommend Madoff to clients). How can investors avoid falling for a similar scheme in the future? No investment strategy is foolproof, but Roth, who ranks third in Bloomberg's 2008 ranking of wealth managers, says there are a few key questions to ask when vetting your financial advisor. He spoke with NEWSWEEK's Sarah Kliff about how to steer clear of a Madoff scheme, select the best advisor and stay steady in a rocky market. Excerpts:

NEWSWEEK: What can investors learn from the Madoff scandal?
Evan Roth: Reflect on how you ended up with Madoff in the first place ...There were some obvious red flags [with Madoff] that I think everybody, even those who aren't financially sophisticated, are now aware of. I'd say we've personally had a lot of clients who have called to say thank you. I think investors have learned that you should know where your money is custodied. Investors need to feel comfortable that there is a check and balance between where money is held and who is making those investments, what auditors and accountants are being used. In the end, I think it comes down to sound principles of investing. It was easy for Bernie, given his charms and connections; seeing through that on your own is difficult. You need somebody who is sitting on the same side of the table as you, since some of this stuff can be pretty complicated.

How can investors avoid becoming the victim of a Madoff scam?
I believe in the benefit of having a financial advisor between you and a Madoff. Madoff is not an advisor. Madoff is a money manager, whose job it was not to ask you what should be your appropriate [investment strategy], do you own bonds, what are you saving for. He just took the money and invested it. An advisor will then ask a manager questions to be able to evaluate them and their appropriateness [for your portfolio].

How can you tell if your advisor is asking the right questions?
Use common sense. If you ask your advisor, what kind of questions they're asking, it should feel to you like they've got a full command, they understand, they've done reference checking, and there's an appropriate amount of transparency. On top of that, you need to say to your adviser, "I want to be sure that even if you're wrong, if there's some landmine in my portfolio that you haven't uncovered, that you have me diversified enough to survive."

What questions should investors ask their financial advisors, who are the ones dealing with money managers like Madoff?
The first is: are there any financial relationships that you have with money managers? Are there referral fees? Is there anything else? It's a good, prudent question. Those things aren't wrong, but you should make sure those things are discussed. I think next is talking about what makes [the financial adviser] comfortable that this is a good investment. At our firm, if we don't understand what the manager is doing, we won't invest. We aren't willing to make relationships because of track records or because of personal relationships. Our role is [and the role of a financial advisor should be] understanding what it is a manager has earned and how he's earned it. That's something that a financial advisor should be able to understand and translate to a client.

Financial advisors obviously have a certain level of expertise. How much should the investor aim to understand, and how much should they leave in their advisor ' s hands?
It is a balance. You don't want to perform surgery on yourself, but when you head into an operating room you want to make sure you're comfortable. There's no reason or need to hire somebody who isn't any more capable than you are. But you do need to know when you ask questions what you get is a level of comfort that the person you're trusting is somebody.

With the combination of the Madoff scheme, collapsing banks and market crashes over the past year, a lot of investors are pretty anxious. Should investors be pulling out of the market at all?
There's a nervousness that every manager is a Madoff, which I understand. That's why you need to be having conversations with your advisor and ask about that. There's a mental-health aspect to it. Your investments shouldn't make you so crazy that you can't sleep or think about the future. But talk to your financial advisor, who is going to ask, why do you feel the need to do this? A lot of times clients will talk themselves out of it when an advisor starts asking why they're getting out or what their plan is for getting back in. And keep going to your therapy sessions.

And what about investments? Any sense in changing those?
I know it feels like you have a sense of control if you make changes. You feel like you're not a sitting duck. If you are going to make changes … you need to be disciplined about not just reacting. Even in a bad market, you still have to be opportunistic, because there are some tremendous things coming up … you name the asset class—energy, health care, financials, emerging markets—there are lots of interesting companies that will be good investments. What that means is if you hire good managers, who know how to find those companies, you're in a good place.