I was having lunch with a client a few weeks ago and he said, “Ron, you should write an article about how to protect yourself from Ponzi schemes.” Then last week, we had a meeting with our accountant and he suggested we do the same. He also wanted us to speak at a conference he had schedule on this topic. Actually, I wrote two articles late last year and earlier this year about Bernard Madoff and how he engineered his Ponzi scheme. I guess now that Madoff has been sentenced to 150 years in prison, the topic is relevant again. Then again, being on guard against fraud and financial abuse is always relevant.
The Issue of Custody
First, we need to distinguish between the individual money manager who has custody of the money they are managing as opposed to what we do as your advisor and fiduciary, which is to use an independent custodian to safeguard your funds.
Madoff was managing money for clients as an individual manager who, like many hedge fund managers, also had custody of his investors’ funds. He did not use an outside custodian or trust company to safeguard the money under his management. Therefore, he could – and did – send out bogus account statements to his clients. The clients had no way to verify if the numbers on the statement were accurate.
While we also send our clients performance reports every quarter, we know that our custodians (Charles Schwab and TD Ameritrade) also send a monthly account statement and transaction reports reflecting activity in client accounts. Clients can, and often do, compare our reports with those issued by the custodians.
This simple act of having a custodian for your money in any advisory relationship can help prevent anyone intent on wrongdoing from perpetuating a Ponzi scheme. That’s because they don’t have direct access to the money and/or the investments in the account. They are only authorized to manage the account on your behalf.
Registered With the SEC
The next step is to make sure that whoever you are investing with is registered with the Securities and Exchange Commission (SEC) as a Registered Investment Advisor (RIA). This makes the RIA firm subject to surprise audits by the SEC.
R. W. Rogé & Company is an SEC-registered firm. We are periodically audited by the SEC and have one of the best compliance programs of any firm that I know.
Mutual Funds, Not Hedge Funds
In addition, using mutual funds to build your portfolio gives you an added layer of protection since they are required to not only have a custodian, but also have the following:
- A trustee
- An independent Board of Directors
- SEC Registration and Filing (Plan for the Mutual Fund) Rules and Regulations
- Auditors: State Public Authorities Control Board (PACB)-type audit
- Accountant administrator
- A transfer agent
- A clearing agent
- Custodian/Trust Company
- Unannounced SEC audits and exams
So as you can see, with a mutual fund, there are just too many independent people and organizations involved to get away with a Ponzi scheme.
Don’t Have All Your Eggs in One Basket
As an added layer of protection, we use a multiple-manager approach. This concept involves the utilization of many mutual funds in our portfolios. This multiple-manager concept helps to further reduce risk by allocating assets among many funds and managers.
Warning About “Fund of Funds” Hedge Funds
The “fund of funds” strategy, in which a mutual fund invests in other mutual funds rather than individual securities to provide even wider diversification, has long been used in the mutual fund world. It is also used in the hedge fund universe, where such “fund of funds” claim to invest with half a dozen or more different hedge fund managers. That might lead you to believe you are getting diversification among managers. In the case of Madoff, many of these “fund of funds” or “feeder funds” had the majority of their money with Madoff, unbeknownst to investors. So if you should be tempted to use one of these “fund of funds” hedge funds, you need to do your homework not only on the fund itself but also on each of the underlying funds and their managers. Do they utilize a custodian or trust company and who are they? Do they use a reputable auditing firm and who are they? Are they registered with the SEC? If not, why not? As you can see, this can get very complex.
Keeping it Simple … and Honest
If you want to keep things simple, utilize a portfolio of mutual funds. Over the years we have shied away from hedge funds (even though they had become very popular after 2001 with promises to make money in both up and down markets). The biggest reason is lack of transparency, but there are many other reasons. You can get a more detailed explanation on our perspective in our book, The Banker and the Fisherman – Lessons in Life Happiness and Wealth for the 21st Century. Section 3, page 75. Title: To Hedge or Not to Hedge?
Let an Expert Do the Work for You
Our clients let us worry about risk control. We have been very good at controlling risk for our clients for more than two decades. We are happy to report that we have had no exposure to Madoff or any other Ponzi-scheme operators reported recently. We have also avoided exposure to such events as the corporate and accounting scandals (Enron, Tyco, etc.) and the mutual fund scandals (after-hours trading). Perhaps some of it is luck, but a large part of it is our rigorous due diligence process and the fact that our firm is “fee-only.” Operating as a “fee-only” advisor we avoid conflicts of interest by working for, and being paid by, our clients directly and not by a third party (such as a mutual fund company that pays commissions on the sale of its funds). We operate as fiduciary and take very seriously the trust you have placed in us.