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8 | Letter from America
managers are presumed by the authorities to volatile bear markets when the celebrity risk averse will want to avoid having more
be sophisticated enough to know better, thus analysts and investment managers of the than $500,000 with any single broker unless
not needing the government’s protection. boom years – the “prophets” of the new era -- that broker has supplemental insurance in
The lawsuits have already started, with are discredited. Think back to the technology addition to the standard SIPC.
investors suing their financial advisors and bubble of the late 1990s and the instant In the case of financial advisors, pay
hedge fund managers for their failures in due “experts” it produced. Most have faded into attention to what banks or brokers the
diligence. Though we cannot comment on the obscurity or have left the financial services advisor uses for trading and custody. There is
merit of any of these suits, we would tend to industry altogether. Some – such as former nothing wrong with employing a small,
sympathise with the plaintiffs. When a Merrill Lynch analyst Henry Blodget and independent advisor, and many investors
financial advisor accepts client fees, it is former Credit Suisse First Boston investment prize such advisors for their independence
assumed that the advisor is offering his or her banker Frank Quattrone – even faced lengthy and objectivity. But if you do go with a small
expertise in return. Failure to question trials for various bubble-related offenses (to independent, make sure that the advisor is
Madoff’s abnormally high and abnormally be fair, neither were found guilty). But of holding your assets at a reputable custodian
consistent returns – as prudent analysts and course, the biggest scandal of the 1990s and and that you receive statements directly from
advisors rightly did – is a sign of either early 2000s was that of the Enron the custodian in addition to any statements
negligence or incompetence, and in either Corporation, which for many became the you receive from the advisor. If the custodian
case the advisor in question carries some symbol of the excesses of the era. Enron’s is not a large, household name, you should at
amount of responsibility. fraudulent accounting, hiding debts and least ask to see the audited financial
Bernard Madoff was not the only major losses in special purpose entities that were not statements. This should have been a major
scammer to be exposed in the past year, reported in the firm’s financial statements, red flag to Madoff investors. A firm of
though he was certainly the one with the cost investors billions and led to the ruin of Madoff’s size and complexity should have
highest profile. Sir Robert Allen Stanford, Arthur Andersen, the company’s auditor and used a Big 4 accounting firm, or at least
originally of Texas but knighted as a citizen of one of the largest and most respected something significantly bigger than the firm
Antigua and Barbuda, also was charged in accounting firms in the world. he used – a three-person outfit that operated
early 2009 with running a massive Ponzi In the case of Bernard Madoff, his Ponzi out of a suburban New York shopping centre.
scheme through his Stanford Financial scheme might have continued undetected for Perhaps most importantly, if returns look
Group, primarily through his offices in the several more years had it not been for the too good to be true then they probably are.
Caribbean. market collapse that began in late 2007. Even Warren Buffett – considered by many to
Moving further south, Argentine private Virtually all money managers lost money in be the greatest investor of all time – has the
banker Hernan Arbizu, while working with 2008, and most lost a staggering amount. The occasional bad year. His Berkshire Hathaway
UBS and Chase, allegedly raided the accounts few who actually made money – such as lost half of its value in 2008. Even though Mr.
of some wealthy South American clients to hedge fund manager John Paulson – did so by Buffet has resoundingly beaten the market
cover shortfalls in promised returns to others, aggressively shorting the financial and real over his career, his returns are still correlated
sometimes personally flying from South estate sectors. No one questioned how Mr. to the market, meaning that they tend to
America to New York to do so. Though not Paulson made his money; he was very move in the same direction over time. If a
technically a Ponzi scheme, Mr. Arbizu was forthright in explaining his strategy. But Mr. manager’s performance differs wildly from his
certainly robbing Peter to pay Paul, so to Madoff remained silent as to how his funds or her peers and benchmark, they should
speak, in order to fraudulently inflate his managed to avoid catastrophe, and their odd have a good explanation as to why in their
clients’ returns. consistency amidst the chaos began to look annual reports. Generally, managers are
And of course, though there is no single increasingly suspicious. Finally, perhaps proud of their exploits and want to tell you
“poster boy” for the housing and credit crisis knowing that an investigation into his firm about them. If they are reluctant to do so, this
that caused the implosion of the global was imminent. Madoff admitted to his sons should be a warning sign.
banking system in 2007 and 2008, there was that the firm’s success was “one big lie.” His Finally, high net worth investors should be
widespread fraud (or at the very least gross sons then informed the FBI, and the rest is particularly careful. Despite widespread
irresponsibility) at nearly every link in the history. perceptions to the contrary, financial
chain. This includes consumers who lied or Perhaps the most important question now regulations are generally designed to protect
withheld information on mortgage would be “how do we, as investors, avoid smaller investors, not the wealthy – just ask
applications, the bankers and mortgage falling victim to a future Madoff?” Financial those who invested with Madoff via feeder
brokers who either explicitly or tacitly scandals are as old as finance itself; no matter funds! As we said earlier, wealthy investors
encouraged them to do so, the large banks what the response of the regulators might be, are presumed to be sophisticated enough to
who bundled these loans into securities they will not prevent all would-be scandals take care of themselves. So, make sure that
knowing the collateral to be of dubious value, from ensnaring unwitting investors in the you do extra due diligence on potential hedge
and the bond ratings agencies who gave their future. fund, private equity, and limited partnership
stamp of approval to the finished product Unfortunately, there is no easy answer here. deals. Be certain that you understand the
(while being paid to do so by the bond The simplest solution is to diversify. It is risky manager’s strategy and that you are
issuers). to put too high a percentage of your assets comfortable with the risk being taken. Read
Financial fraud (and bad investing too, for into one stock – as those who invested heavily the auditor’s reports. If you do not
that manner) can go undetected for years in Enron discovered. A diversified portfolio is understand the investment, then your money
during bull markets. When stocks are rising essential to reducing your risk to any single is better placed elsewhere. And naturally,
in value, few investors bother to ask company. In the same sense, dividing your don’t allow yourself to be duped by those
questions. It is only during panics and crashes assets among several brokers and advisors will offering the modern equivalent of “a
– when the “tide goes out,” in the words of insure that all of your funds are not lost due company for carrying on an undertaking of
the great Warren Buffet – when we can see to criminal activity by one unscrupulous great advantage, but no one is to know what
“who has been swimming naked.” It is during scam artist. For American investors, the most it is.”
July/August 2009 Investment International www.investmentinternational.com
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