How small investors got burned by Madoff

Bernard Madoff, was arrested Dec. 11, 2008 and charged criminally at federal court in Manhattan with securities fraud in masterminding a massive Ponzi scheme.

The alleged fraud of Bernard Madoff has put the heat on so-called feeders, the giant hedge funds that funneled more than $20 billion to the now-disgraced money manager. But it turns out those players depended on another group of smaller funds and individuals to gather money. The largely unregulated crowd, including accountants, lawyers, investment managers, even doctors, opened the exclusive world of hedge funds to more investors and charged exorbitant fees for the privilege.

A lot of small investors got exposure to Madoff through sub-feeders. The system allowed investors to gain entrée to Madoff with far fewer dollars, thereby expanding his clientele beyond big institutions and billionaires to wealthy individuals of more modest means. Many investors had no idea what they were buying since marketing documents rarely mentioned Madoff by name.

Fees were collected at every level. Investors paid layer upon layer of fees with seemingly little regard for how they ate into gains. Those at the bottom paid the biggest tab and realized the smallest returns; and now only see their investments disappear.

Lessons from tumultuous 2008

We just left the tumultuous year 2008, when U.S. stock market sank almost 40 percent, non-U.S. developed market fell more than 40 percent, and emerging market tumbled more than 50 percent. Investors reacted emotionally and indiscriminately selling their stocks, while hedge funds were forced by clients’ liquidation to dump their stock position. Stock went for roller coaster rides indicated by volatility index VIX that top all-time high of 80 mark. All of these cost investors greatly.

Entering this new year of 2009, investors should learn the lesson of the 2008. John C. Bogle, the founder and former chief executive of the Vanguard Group of Mutual Funds, shared his following thought about Six Lesson for Investor, as he wrote on The Wall Street Journal.

Beware of market forecasts, even by experts.

…Strategists aren't always wrong. But they have been consistent, betting year after year that the market will rise. Thus, they got it about right in 2004, 2006 and 2007, but also totally missed the market declines in 2000, 2001 and 2002, and vastly underestimated the resurgence in 2003…

Never underrate the importance of asset allocation.

…With all the focus on historical returns that greatly favor stocks, don't ignore bonds. Consider not only the probabilities of future returns on stocks, but the consequences if you are wrong…

Mutual funds with superior performance records often falter.

… Chasing past performance is all too often a loser's game…

Owning the market remains the strategy of choice.

…Active management strategies as a group lose because they are expensive. Passive indexing strategies win because they are cheap…

Look before you leap into alternative asset classes.

…When the investment grass looks greener on the other side of the fence, look twice before you leap…

Beware of financial innovation.

…Most of financial innovation is designed to enrich the innovators, not investors…