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Graham Macdonald MBMG International Ltd. Nominated for the Lorenzo Natali Prize |
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Do not be conned, part 2
Another defining feature of Ponzi schemes - and another
reason they can be difficult to spot - is that their initial unconditional,
high, fixed returns typically encourage many of the original investors to
re-invest their capital and profits, rather than redeeming their holdings.
This feeds the illusion of an investment that others fear missing out on, and
thus are quick to pile into, while also preventing the model from being tested
by the usual market liquidity conditions - that is, normal periods of net
outflows.
Most of us can still remember the aura of success that the name Madoff exuded in
the months preceding the namesake company’s eventual collapse - as well as the
shock, subsequently, that so many well-respected financial experts (not to
mention regulators) had been taken in by the scam.
As stated last week, Charles Ponzi was an early American financial products
innovator who achieved notoriety in the years just after World War I, after he
came up with an investment scheme that spectacularly defrauded thousands of
investors - and in the process gave his name to future investment entities of a
similarly flawed nature.
In the case of Ponzi’s original scheme, one potential red flag that some
investors might have spotted, had they known what to be on the look-out for, was
Ponzi’s litigiousness. Early on, Ponzi successfully sued a writer who had
suggested that it was impossible to deliver as high fixed returns as Ponzi was
promising. This discouraged further investigative journalism that might have
highlighted the problems with his scheme earlier. Instead, as history now tells
us, the Boston Post was still giving Ponzi’s scheme favourable reviews until
just two weeks before its collapse. It is interesting to note that it was at
that point that Clarence Barron, one of America’s most important early financial
journalists and a key figure in the development of Dow Jones & Co and the Wall
Street Journal, observed that Ponzi wasn’t investing in his own company, and
that the size of his scheme exceeded the total number of postal coupons in
circulation - these were his investment category of choice - by a factor of
almost 6,000. Unfortunately, no-one followed up on this.
What, then, should an investor look out for today, in order to avoid Pop Ponzi’s
genetically-flawed descendants?
The first warning sign, of course, is an investment that appears too good to be
true. On the other hand, advisers do not get prizes for choosing investments
that are not any good - so by itself, this is a poor clue.
Therefore, every adviser kicking the tyres of an investment seemingly good
enough to be worth considering needs to understand that his or her due diligence
processes must be thorough. More thorough, indeed, than has been the norm until
now for some, if recent media reports of investors having been put into
less-than-ideal schemes are to be believed.
Indeed, many of the considerations that may have influenced advisers in the past
might need to be revisited. In particular, advisers should be on the look-out
for:
- Plausible stories, backed up by credible assets, but priced using artificial
valuation models. Such investment stories abound across a wide range of
seemingly attractive underlying asset classes, including property, resources and
“financial contracts”, such as receivables, development mortgages, or litigation
funding.
- Open-ended structures that (apparently) pay high fixed or consistent returns.
The problems can arise when these are wrapped around illiquid or hard-to-price
assets, such as highly-specialised properties or storage-unit container rentals.
Being open-ended facilitates inflows, which repay redeeming early investors, and
can give an impression of liquidity that may be false. As occurred during the
financial crisis in 2008, open-ended funds can run into problems when too many
investors head for the exits at the same time that asset prices collapse.
- A vague affiliation is claimed with well-known auditors, administrators or
custodians, but the nature and limitations of the affiliation is not made clear.
For example, an auditor whose mandate is simply to confirm valuations that have
been prepared in line with stated models may well give unqualified audit
opinions, whatever the limitations of the subjective model itself actually might
be.
- Schemes that have attached themselves to worthwhile causes, which a sceptical
observer might dismiss as a cynical way to distract attention from the
offering’s deficiencies through ‘reflected respectability’. An example of this
might be the promotion of green credentials by forestry funds, exploiting
investors’ understandable desires to “save the planet”, while racking up 15% a
year in “fixed” returns.
- Schemes whose promoters are quick to threaten legal action, and make frequent
use of the device to silence critics. (From first-hand experience, I know how
quickly dubious schemes move to threaten litigation against any unfavourable
analysis.) What you want to see is a well-argued, numerically sound explanation
of just why the critics are wrong.
- Unusually high incentives to introducers are also a typical feature of “mark
to model” - if the underlying numbers are totally divorced from reality, then
the hard cash in the pot can be spread around promoters and introducers very
generously. Ponzi did the same thing, using a highly-paid team of distributors.
The numbers say it all: if a 15% fixed return from 100% of the capital is
unachievable, imagine how much more difficult it would be to realise if some 20%
or more of invested capital is paid out to the parties responsible for devising
and distributing the schemes, and never even reaches the investment assets.
Of course, there are exceptions to these warning signs. Most investment funds,
for example, are open-ended, and the vast majority of these are respectable and
robust and have well-known auditors, custodians and administrators.
To be continued…
The above data and research was compiled from sources
believed to be reliable. However, neither MBMG International Ltd nor its
officers can accept any liability for any errors or omissions in the
above article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of reading the
above article. For more information please contact Graham Macdonald on
[email protected] |
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