Five Lessons for Investors From the Madoff Scandal

4) Do Your Due Diligence

There were fundamental problems with the Madoff fund, say investment professionals familiar with the case. One was the absence of basic legal disclosures on the broker's statements he provided. Another was the absence of high-profile accounting and auditing teams working on the Madoff books.

In other words, more red flags.

"I would guess there was a lot of mischief being handed to the auditors that prevented this from being exposed sooner, because no auditor regardless of size would go along with a crime of this level and this magnitude," says Jordan Kimmel, a fund manager with Magnet Investing in Randolph, N.J.

"This is one of the clearest lessons that there are top-flight auditors who do look more carefully at more items, and the use of real small-time unknown auditors on a fund this size has been sending out loud warning signals for years."

The problem in the Madoff case was that he was so well-insulated, with a five-year rate of return and numerous testimonials from high-roller clients, that it was difficult for many investors to sift through the static and find out how the fund was being managed.

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"Once you get to the point where you can show a five-year rate of return and you have high-quality references—people who have been paid and can vouch for those rates of return—then those things can grow very quickly into a large fraud," says Leone, the former US Attorney. "Then the only thing that stops them is when they get so large they collapse of their own weight or something bad happens in the economy that exposes the scheme."

Which leads to the final point: That when there isn't a sufficient level of transparency, when others vouch for a manager's character, and when returns are absolutely irresistible, it's best to keep in mind that ...

5) If It Looks Too Good to Be True ...

Then yes, it probably is.

And that may be the great lesson in the Madoff case, that even the shrewdest investors can get trapped by a pretty house of cards just waiting to get blown over.

"When people see returns that are too good to be true or extraordinarily high, they should always, invariably, without exception, their antennae should vibrate that whatever this investment vehicle is it's got to carry with it a high rate of risk," Leone says. "There's no free lunch."

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Even for those who still can't resist the temptation, Casserly's strategy of taking a small taste and seeing what happens from there provides shelter from total calamity.

"If it does fall apart you're not going to be happy but at least you were able to scratch that itch," she says. "It's like playing the lottery."

In this case, though, the losers are spread far and wide: Investors, charities, corporations and even the hedge funds themselves, which have sustained another black eye during a difficult year for the industry.

For the market, there will be many lessons to be learned, which no doubt will be dissected well into the future.

"Could it have been avoided?" Kimmel says. "Only through more due diligence, but you could even say that criminals have a way of figuring out how to go around each obstacle that gets in front of them.

"You come up with a better mousetrap, the mouse just figures a way to get around it. This was, in fact, a rat."

© 2009 CNBC.com

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