How to Avoid Hedge-Fund Scams

News of Bernard Madoff’s alleged $50 billion investor fraud stunned Wall Street Friday, causing a “total body blow,” Cramer said, to investor confidence.

As the Mad Money host pointed out just last night, the average investor already mistrusts the market. So this latest revelation only makes things worse. Especially because Madoff rooked the richest of the rich, and not the mom-and-pop stock traders. If the upper crust gets taken, what’s that mean for the rest of us?

Actually, Cramer thinks any Homegamer could have spotted the problem if they knew to look for just a few key signs. There are red flags anyone could recognize. So he laid them out to make sure viewers never become victims to a similar scam.

1. Be careful if your monthly brokerage statements baffle you. If the methods by which your fund manager is generating money are unclear to you, get out, Cramer said. If fund manager can’t explain his strategies in plain English – or worse, he won’t explain them to you – then leave.

2. This is a cliché, but there’s a reason it’s lasted so long: If it sounds too good to be true, it probably is. Madoff was allegedly performing so well that he never had a bad quarter or a down year – even during the most volatile of markets. No one is that good, Cramer said.

3. Question the fee structure. Normally, hedge funds charge 2% of total assets managed and 20% of the profits. But Madoff earned commissions. That means he made money, not by generating returns to his investors, but by buying and selling securities. This, too, is proof you’re dealing with a bad fund manager.

A final tip-off that Madoff’s clients should have had their antennae raised is that he operated his own broker-dealer firm. He was his own broker. And that made it easier to hide any kind of fraud, Cramer said. Watch out if you’re dealing with a fund that does its own clearing.

Questions for Cramer?

Questions, comments, suggestions for the Mad Money website?