– 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.