07/06/2010 09:49 pm ET | Updated May 25, 2011

Lewis and Markopolos: Insights for Turbulent Times

These two books are must reads for investors:

The Big Short, by Michael Lewis (W. W. Norton & Company); and
No One Would Listen, by Harry Markopolos (Wiley).

Read them in that order.

In 2006, when I wrote The Smartest Investment Book You'll Ever Read, the stock and housing markets were booming. No one anticipated the global financial crises that started in the spring of 2007. However, I cautioned investors not to rely on brokers, who I characterized as "emperors with no clothes", selling an expertise they don't have to gullible investors who want to believe they do.

Michael Lewis goes further. He exposes the securities industry as not only incompetent, but also corrupt, brimming with overconfidence and almost hopelessly stupid.

Steve Eisman, the hedge fund manager who made a fortune shorting the stocks of financial firms and the subprime market, is quoted by Lewis as giving this rationale about why he shorted Merrill Lynch stock:

"We have a simple thesis" said Eisman. "There is going to be a calamity and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1980's, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit."

Eisman turned out to be prescient. Merrill took a $50 billion hit in the subprime debacle. It was sold to Bank of America to avoid a total financial collapse.

Lewis is most persuasive when he exposes brokers and investment bankers as morally bankrupt. They will say or do anything to get your money, without disclosing you are the sucker at the other end of a trade from which they are often making hidden and undisclosed profits.

Lewis is not alone in his condemnation. Noted author Thomas Friedman summed up the cause of the financial meltdown as involving "... a broad national breakdown in personal responsibility, government regulation and financial ethics."

Investors who have been pillaged by their brokers certainly cannot count on the SEC or FINRA for comfort or redress. Harry Markopolos tried for over 8 years to get the SEC to take action against Madoff. He provided a blueprint that did not require a bloodhound to follow. Over $50 billion in losses could have been prevented merely by requesting Madoff's trade tickets. If he produced fraudulent tickets he would have been exposed because those tickets would not match with the time and sales of the exchanges. The SEC ignored the evidence handed to them by Markopolos on a silver platter, in part because the head of the New York office did not like him.

Even in today's environment, it is far more likely that an SEC examiner will ask for an employment application during an audit than for the information that would expose a fraud.

Two recent studies reaffirm the overwhelming data indicating the advice given by brokers to invest in actively managed funds (funds which attempt to beat a given benchmark) is harmful to investors.

One study reported in Time Magazine by Standard & Poors demonstrates the folly of relying on past performance in picking mutual funds. Over 90% of funds that performed well for a five year period were unable to repeat that performance for the following five years. Why then are brokers touting the past performance of the mutual funds they recommend?

A new study by Eugene Fama and Kenneth French found that outperformance by actively managed funds can be explained by luck and is not evidence of skill. The well-credentialed authors conclude investors should "... want low-fee, passive funds, unless you feel like paying these active managers the fees for basically not having performance that can be documented."

Recently, I presented a proposal to an employer with a $30 million 401(k) plan. Our investment options were limited to pre-allocated portfolios of low cost, passively managed funds. We accepted full fiduciary responsibility under 3(38) of ERISA. All our fees were fully transparent. We accept no "revenue sharing" from funds seeking to be included as investment options.

Our competition was a major brokerage firm. It proposed a list of actively managed funds, with excellent five year track records. It disclosed it accepted revenue sharing payments from these funds. It could not accept 3(38) ERISA fiduciary responsibility because of its receipt of these payments.

We lost. The broker won.

They wouldn't listen.

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