Avoid Being Scammed!

You can hardly blame clients of investment managers for having a real sense of mistrust these days. How can they be sure their investment manager isn’t going to disappear with their hard-earned assets? In many life situations, it is difficult to know who to trust, especially in the choice of an investment manager.

This issue affects our clients, and it affects the people working here. The phone hasn’t been ringing so much these days with calls from prospective clients. Partly this is due to the gruesome bear market we have experienced, but much of it is that prospective clients don’t know who to trust. Getting a 2% CD rate begins to sound good compared to the possibility of being duped out of your money, as portrayed in the daily news cycle.

But most of our clients can’t afford to retire on CDs. Earlier generations could get by with CDs because their pension and Social Security incomes provided for most of their spending needs. These days there are few pensions to be had and many of these are under pressure. It’s now required that each individual save and invest intelligently in order to produce adequate retirement income. So who to trust?

The Securities and Exchange Commission’s website posts a list of questions to ask any financial professional. Could these be used to detect a scam artist?

• What experience do you have, especially with people in my circumstances?
• Where did you go to school? What is your recent employment history?
• What licenses do you hold? Are you registered with the SEC, a state, or FINRA?
• What products and services do you offer?
• Can you only recommend a limited number of products or services to me? If so, why?
• How are you paid for your services? What is your usual hourly rate, flat fee, or commission?
• Have you ever been disciplined by any government regulator for unethical or improper conduct or been sued by a client who was not happy with the work you did?
• For registered investment advisers, will you send me a copy of both parts of your Form ADV?

While these are good questions to ask, the Madoffs of this world can pass this test with flying colors. Thus these questions alone aren’t adequate to protect you from someone conniving to steal your money.

We submit that it is the investing environment that provides aid and comfort to the scam artist. So in addition to asking about the investment manager’s credentials, you must also understand where your money is and who can access it.

What do you need to protect yourself? We believe the following is extremely useful:

• Always use a third-party custodian.
• Use investments that are priced daily in a public market.
• Use investments that you understand.
• Avoid anything that sounds too good to be true.
• Avoid anything that is proprietary, secret, or touted as exclusive.
• Know how much the fee is and how it is paid.
• Lastly, trust with verification.

Always use a third-party custodian:
A third-party custodian gives you another layer of checks and balances. The custodian is legally required to protect your assets from everyone – including your investment manager. For example, Schwab prevents investment managers from withdrawing unreasonable management fees. Additionally, the custodian should send statements directly to you at least quarterly (the statements must not pass through the investment manager’s firm). Choose your custodian well. (Schwab is well-respected.)

Madoff did not use a third-party custodian for his clients. Therefore all the money went through his hands. He was able to fake statements and investments since no independent parties were watching.

Use investments that are priced daily in a public market:
If you can independently evaluate your portfolio any day you wish, then you have eliminated a major source of fraud. Some fraudsters create fake statements with any values needed to keep you convinced the portfolio is doing well. Publicly traded securities are easily valued so the fraudster prefers to avoid them.

Use investments that you understand:
It’s much harder to fake returns and statements for securities that are easily understood and verified independently. Stocks, bonds, and mutual funds are all easy to monitor. Hedge funds and private equity deals are not.

Avoid anything that sounds too good to be true:
Promises of future returns are the ultimate warning sign. No one knows the future, and if they did, they sure wouldn’t be telling us. Promises of positive returns under all conditions are just lies for anything other than risk-free securities: Savings accounts, CDs, and Treasury bills are about it.

Just by following the news you can get a good idea of how the investment markets are doing. Your investments should be performing in a similar range, otherwise, beware.

Part of Madoff’s mystique was that he had delivered positive monthly returns for decades with almost no exceptions. This must be a huge red flag to any sensible investor. Don’t let greed get in the way of common sense. Anytime someone offers you profits that sound exceptionally good, you should:

1. Wonder why me instead of his best friends and family?
2. Wonder why not keep the process a secret so it won’t get copied and possibly ruined?

Avoid anything that is proprietary or touted as exclusive:
This goes along with using investments that are priced daily in the open market and easily verified. Propriety and exclusive implies investments or a strategy that are hidden in a black box and unverifiable.

Know how much the fee is and how it is paid:
It should be very clear how much your investment manager is paid and how she/he is paid. If you don’t know for sure, ask.

Lastly, trust with verification:
After you have found an investment manager that passes all the above tests, you need to trust them so the relationship works for all. However, you must verify that the relationship stays honest.

• Review your monthly statements from the independent custodian for anything unusual like mysterious investments. Contact your custodian right away if you see any withdrawals you didn’t make or authorize.
• Monitor your performance and make sure it is about what you should expect from the types of investments you are using. If you are making money in a year when most others are losing, you should be suspicious not gleeful.