December will mark the three year anniversary of when it was first discovered that Bernard Madoff defrauded his clients for as much as $50 billion, in one of the largest financial Ponzi schemes in history. The money management industry sustained a significant black eye to its reputation as a result of Madoff's fraud. Unfortunately, there are likely to be future thefts of client funds, though likely not on Madoff's scale. As with any industry, certain players in the investment field will resort to cheating, in an attempt to get ahead. Below are five issues to consider in order to identify, and best avoid, investment fraud.
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Too Good to be True Returns
An article in The Economist, written shortly after the Madoff scandal broke, cited smooth investment returns as a potential warning sign, given that markets are inherently volatile. In the case of Madoff, investors began to question the steady "returns" of approximately 1% per month he posted, in a period of abnormally-high market fluctuations. He even lulled the SEC and many large, well-respected financial institutions into complacency, with supposedly savvy risk-control procedures. Excessive returns compared to benchmarks should also be monitored; in 1981 Dennis Grudman ran off with funds he attracted from some 400 investors, by reporting short-term returns as high as 85%. (For related reading, see How To Avoid Falling Prey To The Next Madoff Scam.)
Another key safeguard includes reference checks, which should be standard when entering into any business relationship. Of course, many Madoff investors were referred from friends and colleagues, but others did end up avoiding his dubious services, after performing due diligence and related background checks on his character and operations. Other financial services industry regulatory bodies can also assist in checking out the background of an investment manager. This includes the Financial Industry Regulatory Authority's (FINRA) Broker Check network, which is available online.
A key reason that Madoff was able to operate undetected for many years, was that he operated as his own broker-dealer. This allowed him to falsify trade information and statements that were sent out to clients. Using an outside financial firm as a custodian can help allay these concerns, as the outside party becomes responsible for key back-office functions, including the execution and settlement of trades and the preparation and mailing of client statements. Large, well-respected firms that serve this function include Fidelity and large custodial banks, including State Street and Northern Trust. Clients can also go directly to these custodians to verify asset levels and returns.
Skin in the Game
The phrases "skin in the game," "eating your own cooking" or "putting your money where your mouth is," all refer to the extent that an investment manager has his, or her, own money invested in the same strategies as clients. This serves a number of benefits, including confidence in the manager's own strategy to aligning manager and customer interests, such as avoiding taking excessive risk to keeping fund expenses as low as possible. For commingled assets, this can consist of money committed to the manager's own hedge or mutual fund. There is no set rule for the percentage of the manager's own capital invested along with clients, but the higher, the better. Well-respected managers and businessmen, including Warren Buffett and the managers of the Longleaf Partners, have significant portions of their personal wealth invested along with their investors.
Additionally, the illusions of secrecy or exclusivity and/or the inability or unwillingness to clearly explain an investment strategy, should be met with suspicion. Finally, and perhaps not completely in jest, Lucy Kellaway, a popular journalist in the "Financial Times," has speculated that a menacing name could indicate the degree to which an individual can be trusted. In her words, Bernard Madoff "made-off" with client funds, while Michael Milken "milked 'em" out of their funds, while at the helm of Drexel Burnham Lambert. (For related reading, see 4 History-Making Wall Street Crooks.)
The Bottom Line
There is no fool-proof strategy to avoid investor fraud, but there are a number of approaches investors can take to minimize the risk of an outside manager using his, or her, hard-earned funds improperly. Taking these five tips into consideration is a good step in protecting yoursef and your investments.