Minimizing exposure to investment management fraud

By Mark Williams
December 16, 2008

williams_mark– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner.  The opinions expressed are his own. —

It looks like the oldest trick in the book was used to allegedly bilk wealthy investors, banks, charities, endowments, and hedge funds out of their money.  How could sophisticated investors have been duped by what could potentially be the largest Ponzi scheme in U.S. history?  The answer may center on their due diligence prior to signing up with the investment firm run by Bernard Madoff, accused of masterminding the massive fraud.

Due diligence is the rigorous process undertaken to evaluate the controls, credibility, and capabilities of an investment firm prior to putting money at risk.  This process doesn’t stop once a money manager is chosen, but continues over the life of the relationship.  The $50 billion in reported losses and the fact that this scheme went undetected for so long are stark reminders that there is no substitute for solid investor due diligence and ongoing monitoring.  Unfortunately, it has taken a down market to expose such fraud.

The following are 10 steps to help to reduce the chance of fraud.  (Note: Until a human fraud meter is perfected, such risk can never be completely eliminated.)

1.      Find a great money manager not a great friend.

Make sure the candidate pool is based on professional reputation, capabilities, investment track record, size of audit firm, and level of overall risk controls.  Deciding on the right money manager should be a pure business decision.  Confusing this business relationship with friendship or a person’s golfing handicap can cloud sound judgment.

2.      Conduct your own independent due diligence.

Regardless of who else might be investing with a potential money management firm (relatives, acquaintances, movie stars, or billionaires) don’t neglect your duty of completing your own thorough due diligence.  It’s dangerous to blindly assume that those that have a lot of money can also pick the most honest money managers.

3.      If you can’t do your own due diligence, hire a qualified agent to do it.

There are consultants and hedge funds with the expertise to conduct thorough due diligence.  But delegating this duty does not mean you can consider your work finished.  There must be constant monitoring, reporting, and ongoing dialogue between the investor, the agent, and the investment management firm.

4.      Remember that risk and return always goes together.

Investment returns mirror the level of risk taken, a fundamental investment management principle.  If investment returns are steady, regardless of an up or down market, it would suggest that there is a deviation from this principle.  Returns never lie and are a great “red flag” monitoring tool.

5.      Money management firms are not charities; they are commission driven.

Many good money managers who are not good marketers hire salespersons to talk up their services.  Be aware that the person selling you on an investment manager might be motivated more by their commission than any commitment to help you.  Ask to have all sales commissions put in writing.

6.      Money manager diversification is your best friend.

Large investors should consider diversifying, using more than one investment manager.  Doing so will avoid putting all your eggs in the hands of one firm and will reduce the financial consequences of fraud.

7.      Asking questions is great but getting clear answers is even better.

Investment related questions must be asked frequently with responses monitored and documented.  If questions are not being fully addressed, not provided in writing, or if the story changes over time, it might be a warning sign that it is time to take your money and run.  Examples of basic questions include:

a.      How is the money being invested?

b.      Where are the returns coming from?

c.      What are the portfolio performance benchmarks?

d.      How is the portfolio performing relative to these stated benchmarks?

e.      What is the level of portfolio risk being taken relative to expected return?

8.      Conduct on-going monitoring of the relationship.

Once money managers have been chosen, on-going monitoring is needed to insure that the firm(s) continues to act, walk, and talk as they have represented themselves.  Like fruit, people can rot over time.  You need to know when the fruit flies start appearing.

9.      Good returns do not mean due diligence can be stopped.

With all investment returns come a level of risk.  Make sure your money is not exposed to excessive risk taking.  Be suspicious of consistent returns that do not track with market fluctuations.

10.     Money managers that are highly regulated tend to have reduced levels of fraud.

Fraud can persist anywhere, but banks with investment management divisions are highly regulated at the federal and state level.  For investment clients, these extra layers of oversight can be a safety net against fraud losses.  Banks also tend to be very concerned about reputational risk events and are focused on developing tighter internal controls to minimize fraud.  As added protection, if fraud occurs, banks tend to have more assets to go after when filing legal action.  They also tend to be motivated to settle legitimate fraud based lawsuits to avoid the negative publicity.

14 comments

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None of the above would have prevented investor losses in the recent $50 billion scandal – except for points 7a, 7b and possibly 10. I suggest given our recent experiences with banks, which are well regulated, we can throw 10 out of the window. As far as 7a and 7b, probably the whole point of having professional management is so people doing have to figure out all of those details. So really what we are saying here is that professional investment management is moot – and even worse than moot since the managers get paid commission. This brings me back to a point I’ve made to other investors in the past: If a professional manager knows how to make good money consistently over time, he doesn’t need any retail investors buying his fund. The fact that he needs your money is a good indication he doesn’t know what he is doing.

Posted by Don | Report as abusive

Good advice, but not enough. Investing and speculating are different animals. Speculation is gambling. You can win and you can loose. Over time the result must be zero.
Investing means having confidence in a business and putting our money in it. The business behavior can be monitored and reasonably well foretasted. But, to invest you bust have money. If you borrow money to invest, good luck!
It is time to stop speculation to screw up business. How? simple, tax high income at a 98% rate and give the guy a knighthood at the end of the year!

Posted by carlo testa | Report as abusive

How about this for fraud? What if I put together a bunch of AAA securities made up of mortgages on properties whose values are inflated as well as very likely to default. I can build these very cheap. Now I sell them to my debtors to reduce my debt. Do you think they will figure it out? And what if they do? Now, isn’t this just what happened? We, the US, sold toxic crap mortgage packages to the world to reduce our debt and this was the start of of the current mess! How come these crooks who put this junk together are not going to JAIL. We have, more or less, two million people in prison. Most of whom are minorities who did drugs. Lets put the real criminals in prison. Those people who wrote $500K house loans to a person whose gross was only $30K a year. John

Posted by ginsengjohn | Report as abusive

All good points, but what do you do if you’ve been LIED to ?

You know the old saying : there are no honest fortunes, and the people investing your money are rich, so you do the math !

Posted by Gregg&Brian | Report as abusive

Simple rules are all well and good, but the issue that I would like to see addressed by American commentators is that of national integrity.

American greed and duplicity as exemplified by Enron, Sub-Prime, Madoff, etc, have exported financial hardship and misery to every corner of the globe but I see very little evidence of national shame.

Is there any reason why we should ever trust the USA again

Posted by anton kleinschmidt | Report as abusive

This $50billion ponzi fraud scheme by this hedge fund manager is going to create a bad taste for most investors and you are going to see a mass exodus of funds.

Their will be a lack of trust in the financial system not only from Americans here in the US but from investors worldwide not only because of the ponzi scheme but the toxic mortgages being dumped overseas. One day foreign capital will cease to flow to US like it does in corrupt countries right now. This will really mark the demise of the US and the financial problems faced right now by the US will be nothing compared to what would happen if “trust” of the financial systems were to break down even further.

Those that created the programs so be sent to jail not those that were just doing their job by following them. The senior managements and board of directors of the banks should be the ones to pay for the messes. The government should take out from their paycheck and confiscate their assets until full payment is made. Let them feel some pain for putting millions out of work, out of homes.

Posted by Rshah | Report as abusive

IMHO, those recommendations are pretty close to worthless. Goldman Sachs blamed losses in virtually every asset class for its quarterly loss of $2.1 Billion; so much for diversification. I’m not a financial expert; that’s why I hired one. How do I tell if I’m being lied to?
Who do I complain to if I can’t get my my money back?
Define ‘qualified’.
What’s a benchmark? (Where do I even find a benchmark?)

I have a different set of questions:
pretty much the same questions you ask a potential contractor to work on your house.

are you licensed; how long have you been licensed?
have you ever done this before?
How many times/how long/when?
Are you insured?
Do you do the work or do you hire somebody else to do it?
have you ever been sued?
has anyone ever taken you to court? filed a complaint?
are you being sued at the moment?

We agree on exactly what you’re going to do. You ask me before you make any changes.

Talk to at least 3 different ‘contractors’. I usually ask for references.

For financial advisors:
Where are you putting it?
How do you get paid?
Do I pay you if I lose money? (nothing like paying someone to lose money for you)
How many clients do you have?
How much money are you managing?
How long have you been doing it (in business)?

You may not get complete anwers to those questions, but you have to be comfortable with the answers. In the end, it’s your roof; you’d like it to keep you dry when it rains.

Posted by Chris | Report as abusive

Hedge funds have been a ticking bomb and it went off. Greed of the wealthy caused this animal to awake and its time to pay up. This is not a bad thing.

It is clear the entire financial services industry is under regulated. We have systematically cut to the bone state and federal budgets and all but undermined the SEC, FRB, OCC, etc. From someone who is in regular contact with these entities, they lack the modern business model understanding, the focus, the concrete regulation (“guidance” should be erased from the vocabulary), the pockets, and the systems to combat the core problem. I am all for free markets, but today’s level of oversight is grossly dated and misguided.

Posted by Matt | Report as abusive

Look: this scheme’s been running for decades. At 8% “Investors” got their money back in 12.5 years. After that, it’s pure profit. They spent it on themselves: so did Bernie.

Now they want their capital back, as well? Wall Street types always tells you, when you ask too many questions, too close to the bone: if you can’t afford to lose it, you shouldn’t be putting in the market. Or you’d better know that the best time to pull your chips out of the game is not in the midst of a world-wide financial collapse.

Posted by Heteraetcaetera | Report as abusive

It’s just a matter of time until there is a mass exodus out of US investments by foreigners after the tech bubble, real estate bubble, and now US government debt bubble.

Posted by jon fletzinger | Report as abusive

Don’t overlook that some of us investment advisors work on fees and do not sell anything — charging for our time and the value our counsel.

In our own case, in addition to managing assets for clients, we provide fee-based investment coaching for those clients who prefer to maintain direct control of their assets.

We do agree with the perspective that commission motivated advisors are conflicted and not well aligned with the interests of their clients.

I find your advise number 10 highly interesting.

It should be clearly stated that the US has been one of the most ardent proponents (together with the UK) of preventing regulatory oversight of Hedge Funds in any form.

I think there NUST be a renewed public debate why NOT regulating Hedge Funds is considered a good and appropriate government policy?

Probably the past policies have been driven partly by influential figures like the ex Nasdaq boss? What was his Name? Madoff?

Posted by Bernhard | Report as abusive

The advice is absurd: if you have the time and skills to assess the credibility, controls, and capabilities of the manager; if you understand where the money will be invested, and approve; if you need to hedge your trust [and all your other information, admitting it is not reliable] by using multiple managers; if you believe that there is a valid and reliable relationship between risk and reward; why the devil are you not using this information and energy to avoid the whole mess?

Posted by CyranoRox | Report as abusive

1. Choose a fee only adviser

2. Choose an adviser who uses a third-party custodian to hold your assets. Make sure that third-party is reporting on your investments directly to you.

3. Use more than one strategy.

Posted by Adviser1 | Report as abusive