Avoiding Investment Scams…

remain-alert-sounds-to-good-to-be-true

Madoff…need I say more. In 2009, Bernard Madoff was convicted of running a massive Ponzi scheme using his firm, Madoff Securities LLC and defrauding thousands of investors to the tune of billions of dollars. His victims included not only ordinary mom and pop investors but also some of the so-called “smart” money people running hedge funds and investment banks. The largest among them was Fairfield Greenwich Advisors, a hedge fund which had more than half of their $14.1 billion of assets under management, invested with Madoff’s firm.

So how was Bernie (as he was fondly called) able to perpetuate a $50 billion scam over decades without anyone uncovering it. Apart from having impeccable credentials (former chairman and founding member of NASDAQ) and being a prominent personality on Wall Street, his hedge fund was known to deliver 10% a year regardless of what the markets did, famously called The Madoff Ten. If the promised returns were higher, say 20% or 30% every year, the fraud could have been uncovered a lot sooner. Ten percent a year is not out of the world but achieving that, year in and year out, without any volatility was unbelievable. One of the Madoff’s feeder funds described his investment strategy as follows:

“Typically, a position will consist of the ownership of 30–35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls [options] on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio’s downside.”

Got it.

And Bernie is not alone. There have been several other recent scams where people’s life savings have been swindled by crooks posing as wealth managers or investment advisers, examples below.

In May 2009, Marc S. Drier, a prominent New York lawyer, pleaded guilty to a complex scheme in which hedge funds (“smart” money again) and other investors as well as his clients, lost at least $400 million. Mr. Drier sold counterfeit promissory notes to investors who were tempted by the promise of a high-fixed-rate return in the range of 15%-30% per month (ha…ha…that’s funny) with very little or no “risk”. And he promised that the returns were “guaranteed and insured”.

In February 2009, R. Allen Stanford was charged with perpetrating an $8 billion investment fraud where he cast himself as an offshore investment guru to the gullible investors and institutions. With the help of impressive websites and lavish brochures, his company convinced victims to put money in disreputable or non-existent organizations in foreign countries. The high double digit tax-free annual returns with no “risk” (that word again) were so enticing that thousands of investors lost their entire life savings to this scam.

And then we have some of the biggest and most reputable financial firms who were and are not on the up and up in playing straight with investors or their accounts. This is despite the fact that these mega-banks and institutions are culpable, to a large extent, in almost bringing down the global financial system in the wake of the 2008-2009 financial crisis. The headlines below speak for themselves.

SEC charges Merrill Lynch for misusing customer order information and charging undisclosed trading fees – Jan 25, 2011

Citigroup, Morgan Stanley, UBS and Wells Fargo & Co agreed to pay a combined $9.1 million to settle regulatory claims that they failed to adequately supervise the sale of leveraged and inverse exchange-traded funds by their advisers in 2008 and 2009 – May 1, 2012

FINRA and SEC fine Goldman Sachs $22 million for ‘Trading Huddles’ in which Goldman analysts from its Americas equity research group met with traders from the firm’s securities division, and occasionally equity salespeople. The analysts would then disclose the securities on which they were considering making rating changes and the traders would go out and buy or sell the same securities for the firm, pocketing a nice “little” change- April 12, 2012

Ameriprise Financial Services agreed to pay more than $17 million to settle a complaint that it failed to disclose nearly $31 million received for selling certain investments to its brokerage customers – July 10, 2009

And the list goes on and on.

And then we have MF Global, a futures and options brokerage firm, which filed for chapter 11 bankruptcy when it was discovered that they raided the firm’s client accounts to the tune of $1 billion to cover up for losses in their own proprietary trading accounts. The firm miscalculated the depth of the European debt woes and was leveraged 30:1. When the investments faltered, their losses exploded. Incompetence and stupidity beyond belief.

In light of all these scams and scandals, how can investors protect themselves from having their wallets swiped? Some guidelines below.

1. The first and the biggest one is to Madoff-proof your investment accounts when managed by an investment professional. Madoff’s clients had their accounts with his firm instead of using a third-party custodian like Schwab, E-trade etc. This is a complete no-no in order to avoid falling prey to a Madoff-like scam.

2. If it sounds too good to be true, it normally is. There is no free-lunch, especially on Wall Street. The moment you hear the word “guaranteed and risk-free or safe returns” in the same sentence from an investment manager or an institution, don’t walk…run. Unless of course he is having you buy ultra-safe US treasuries. And remember, 10-year US treasury bonds yield 1.7% annually. So any return higher than this will carry risks.

3. Do you understand the investments being recommended or the investment philosophy being prescribed? If you do not, stay away. Do not make the process of investing any more complicated than it has to be. Avoid anyone dealing in futures, options, currencies and other exotic investments.

4. Avoid leverage.

5. Check your adviser’s credentials. Is he licensed to practice? Is he a fiduciary? A fiduciary is legally required to act in the best interest of his clients. This does not apply to brokers or insurance agents. Brokers are typically glorified salespeople and are more likely going to put you in products which earn them the most commissions while continuously churning your accounts to keep that gravy train going.

6. Smart money is not so smart. The main Bloomberg hedge fund index which tracks 2,697 hedge funds fell 2.2% a year in the last five years. A balanced portfolio on the other hand with 60/40 split between equities and bonds gained 3.5% annually, handily beating the so-called “smart” money investments. And this is without factoring in the additional costs incurred due to excessive trading and taxes.

7. If anyone pitches you a variable annuity or a whole life policy, run again. This does not completely fall into the scam category (maybe close) but it is one of the biggest rip-offs ever perpetrated on the investing public where the only people who seem to get wealthier are the ones selling these crap products and the insurance companies behind them.

8. This is a new one in light of the MF Global fiasco. Make sure that the custodian you or your investment manager use does not get involved in trading their own portfolios. We have seen MF Global implode overnight by betting wrong and then raiding their client accounts for funds. The client accounts will eventually be made whole but not before many sleepless nights. Avoid it if you can.

FINRA has a simple, web-based questionnaire (SCAM METER) which provides information on whether whatever you are pitched is a scam or not.

Follow these few tips and be safe.

Happy Investing.

Image credit – George Newman, Flickr