Learning from the past

Monday, 27 December 2010 From Issue Vol. XVIII No. 52 By  Graham Macdonald

As the famous Spanish philosopher and essayist, George Santayana said “Those who cannot remember the past are condemned to repeat it.”

This adage is particularly true when it comes to the world of investment, a now global arena that is too often championed by con artists.

Full of style, swagger and myriad false promises these industrious snake oil merchants are skilled at profiting from the misfortune of others. But it is not only the inexperienced and gullible who are netted by their promises of unobtainable returns, hardboiled investors who pride themselves on being able to smell a rat are often among their victims.

In this article, we will take a brief look at two of the greatest investment scams of the past century, their common XXXX before shedding light on some of the dodgier types of products that are doing the rounds today.

Hopefully, these will help you learn from the pain of other investors’ bad experiences and save you the bother of learning the hard way.

Ninety years ago, Charles Ponzi launched a postal coupon scheme which sold promissory notes from his Boston base on the East coast of the US, which guaranteed a 50% return in just 45 days. This “financial wizardry” caught the popular imagination and Mr Ponzi managed to quickly net $9.5 million from 10,000 investors.

His promises of total returns of 400% kept the cash flowing in until the bubble burst. Investors then realised they had been chasing fool’s gold as Ponzi’s scheme was nothing but a hollow shell, a well thought out but simple plan that took advantage of human greed by promising something that was unbelievably good - the key is the word “unbelievably” - he had been using cash from his most recent investors to pay the notes that had matured.

The Ponzi scheme had arrived.

Fast-forward to 2008 and meet the former chairman of the Nasdaq Stock Market and member of the board of governors of the National Association of Securities Dealers who some joke “made off” with his clients’ money because it was a destiny born from his surname. Such witticisms, however, are unlikely to bring smiles to the faces of Bernie Madoff’s clients who got nothing when they collectively requested some US$7 billion in redemptions in the wake of the 2008 Financial Crisis.

Madoff’s claim that his secretive investment strategy was “too complicated for outsiders to understand” was laid bare when it was revealed that he was running an old fashioned Ponzi scheme. The 1-2% returns he paid his clients each month came from new money from new investors. Profit came from the simple expanding of his client base to net new unwitting investors.

Both Ponzi and Madoff are linked by both their promises to deliver the undeliverable to investors, and their method of paying off old investors with the money from new ones.

With hindsight, it may seem all too easy to point out that generally in life, things that sound too good to be true generally are. And, to be fair, Madoff had a solid track record of paying his investors the returns he had promised for years until the credit crunch caused too many clients to demand redemptions at the same time.

Today, illiquid assets promising fixed returns are a common feature of some of the more questionable funds being promoted in the market. The more sinister products also incorporate assets that are essentially impossible to value.

Some cater to ethical investors who want to earn decent returns from socially responsible financial products. Many forestry funds fall into this category, because on scrutiny they fail to provide a robust investment strategy to back up their claims of above market rate guaranteed returns.

Market traded timber, as a commodity, has a verifiable price which can be used to forecast the value of an investment in that commodity. Teak is a good example of this. However, for some other timber products, which is not traded, there is no such data.

With no verifiable market price and no empirical/historical data available it is impossible for an investor to check the price assumptions that are used to generate future guaranteed prices and returns on investment. This is something to bear in mind the next time a once in a lifetime forestry fund with guaranteed returns arrives in you email inbox.

Litigation funds are another relatively new product and some of these are essentially based on the same false foundations as they work on the basis that investors cover a portion or all of the costs of litigation cases in exchange for a share of awards granted by the court. But the key question is how do you value a loan that you made to someone that has no repayment value other than the proceeds of successful legal cases? How can you value it in a meaningful way? How do you know that the cases you are funding will be resolved to your benefit?

An illiquid asset, such as a litigation fund, can only be made liquid if it can be traded at market price on the open market with all the pricing issues that entails. But an asset that has no market price cannot be verified and its entire value is based on the assumption that at some future point there will be a market and, therefore, a market price for it or there will be an opportunity to unload it on a private buyer. Once again the odds are loaded against the investor.

There are a number of other similar funds, such as open-ended property funds, that trade illiquidity for fixed returns on assets that cannot be independently valued.

Some key points to remember that could save you from making a bad investment are:

- There is no such thing as a guaranteed return.

- If something sounds too good to be true it generally is.

- With any investment, especially those which sound the most promising, take a step back and take time to check out the claims made by the fund.

Essential questions to ask are:

- How is this asset valued? Are data available that can be used to verify the price assumptions?

- Is the asset illiquid? Can I redeem my investment before maturity if necessary?

If the answer to any of these is negative, then do not invest in the product.

Until then remember, if you are told an investment product is “too complicated to understand” then it is too complicated to risk investing in.

Please let me take this opportunity to wish you all a Merry Xmas and a Happy & Prosperous New Year.

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