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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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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