4 Ways to Manage Your Risk of Investment Fraud

Throughout the past few years, there have been several high-profile fraud cases that have decimated investors. Topping the list is Bernard Madoff ’s Ponzi scheme. In March 2009, Madoff admitted to turning his wealth management business into a massive Ponz scheme that defrauded many investors out of billions of dollars. In the years since the Madoff scheme was uncovered, there have been many more frauds. As long as there are unscrupulous people in the world, there will continue to be investment frauds.

So how can investors protect themselves?:

1. Do your homework. Due diligence is a process of getting to know the investment manager overseeing your portfolio and performing certain checks into their staff and procedures. With privately offered funds or separately managed accounts, due diligence is especially critical.

Although due diligence is a broad topic, it should always involve reference checks. Reference checks should include clients, legal advisors, accountants and compliance consultants. Other good sources of information are the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority websites, which provide information on brokers and investment advisors. For privately offered funds, it is important to obtain financial statements for the fund that have been audited by a reputable audit firm. There are many large and small audit firms with experience auditing privately offered funds.

2. Know your custodian. Having an independent custodian that separately holds and accounts for the investment securities is a good way to lower fraud risk. One of the reasons Madoff was able to keep his scheme going for so long was that he served as the custodian for his clients in addition to being the investment manager. This allowed him to create falsified client account statements. A separate custodian independently sending statements to clients serves as a good check on investment performance.

However, sometimes there are legitimate reasons to couple investment management with custodian functions. In these cases, always ask for an internal control report, which most reputable custodians will be pleased to supply. There are several types of internal control reports for custodians, the most common being a SAS 70 (now called an SSAE 16). However, agreed upon procedures engagements and control attestation reports are also sometimes used. The internal control report should be provided by a reputable independent CPA firm.

3. Do not put your eggs in one basket. It was disheartening to learn of the many people who were wiped out when the Madoff fraud was exposed. These individuals were wiped out because they were so enticed by the fund’s extraordinary performance returns that they invested all of their money with him. Many people think of diversification as a means of lowering their investment risk, but it’s also a very effective way to lower fraud risk. No matter how good you think an investment manager is, keeping your money with several investment managers lowers your risk should one engage in fraud.

4. Be wary of returns that seem be too good to be true. Chances are if an investment’s returns look too good to be true, they may not be real. When an investment manager touts returns that have very little variation from period to period or do not ever have any down periods (even when the market is significantly down), it may be indicative that the “books have been cooked.” Asking your investment manager to explain their returns relative to the benchmark they manage against is a good start to understanding whether the returns make sense.

Investment managers should always be willing to explain their investment strategy and the resulting returns. Attempts to mask the strategy or unwillingness to explain returns should not be tolerated. After all, it is your money, not theirs. If you cannot get reasonable explanations from the people managing your money, it good idea to take your money elsewhere.

Thomas A. Peters can be reached at 215-441-4600, or Email.

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