ARTICLES & REVIEWS
Due Diligence Investor’s Job
London Free Press
Psssst - Have I got an investment for you, friend - outrageous returns, just a quiet circle of people, it's a well-kept secret, don't tell anyone, and it's guaranteed. Sounds too good to be true? Scams are typically exposed at, and around, bear market bottoms. Why? First, downturns make it harder to bring in new money. A pyramid or ponzi scam constantly needs new money to cover distributions to older investors. Without fresh money, it collapses. Secondly, investors tend to become fearful. Even perfectly legitimate investments will see redemptions during downturns, putting additional pressure on the rats.
The latest New York Times bestselling author, Ken Fisher, identifies five signs of financial fraud in his book in "How to Smell a Rat". His five signs that indicate you might be dealing with a rat are:
1) Your advisor has custody of your assets.
This is the number one red flag. Your cheque should never be made “payable” to anything other than a registered dealer who is bonded and regulated by the Ontario Securities Commission. Having your cheque paid to a non-registered dealer is like giving your money to the fox in the hen house. The money manager should not have custody of the assets. In other words, your custodian should be a separate trustee; the money manager or financial advisor should not act as the bank or broker dealer. You need to deposit your money with a third party.
2) Returns are consistently great, almost too good to be true.
In real life, even the best money managers have bad years. Honest money managers aren't ashamed of admitting they make mistakes. The "best" have been only right 70% of the time - that means they're wrong 30% of the time. So when someone comes along guaranteeing a return of 15% to 40% per year when a 10-year bond is 3%, you should be asking questions. So how do these cons lull people for years? Most of them aren't registered and clients who get huge returns don't complain. Madoff's clients believed they were getting the returns he was claiming.
3) The investment strategy isn't understandable.
It’s murky, flashy or too complicated for him or her to describe the investment to you so that it can be easily understood. Most investors hire professionals to do their investing because they want to live their lives, and proceed with their careers, families and hobbies. Rats play on confusing strategies, intentionally aiming to mislead or intimidate. This keeps their clients from questioning them too closely. Don't fall for it - a non-rat advisor will never hesitate to simply and openly discuss strategy because a good strategy should be straight-forward. If your advisor’s strategy seems murky, and he can't or won't explain it, be suspicious. This is a common rat tactic.
4) Your advisor promotes benefits like exclusivity.
You can't quite understand how they do it, but you know it must be legit because your long-time tennis partner uses them and swears by them. You shake your advisor's hand, look into his calm and confident eyes and think you'd know if he were a crook. If someone sells exclusivity, it should raise a red flag; it's a standard tactic among rat artists and con men. Why does this ploy work for so many con artists? Amazingly often in life, if you tell someone they can't have something, they want it even more.
Madoff was the "king" of exclusivity - he claimed he didn't market his services at all. His funds were closed to new investors, or so it appeared. New investors had to be introduced by a trusted source. He even asked investors not to disclose they had funds with him to perpetuate the feeling of an exclusive club.
Secrecy is the ultimate form of exclusivity; so clients are advised to keep quiet and don’t question, which suits a rat perfectly. Exclusivity might make sense for a social club but it doesn't for financial advisors. Be suspicious of claims of exclusivity from anyone trying to sell you an investment.
5) You didn't do your due diligence but a trusted intermediary did.
A trusted friend of influence unknowingly introduces you to rat - “If it’s good enough for him, it’s good enough for me”. What you need to realize was that no matter who you hire or trust, or how many mandates, due diligence is your job, no one else's.
Whether it is the past, present, or future, fraud will always exist. There is fraud being advertised in national newspapers at this moment. Alarm bells should start ringing when your trusted friend introduces you to a fail-safe, secretive, too good to be true investment.
Talk to another professional, your accountant or your lawyer. If it sounds “too good to be true”, it probably is.
