Contrary to conventional wisdom, the biggest risk that investors face isn’t the volatility of the stock market, it’s bad financial advice from expert advisors. What happens when someone you trust provides fraudulent advice that may cause catastrophic losses? How do you identify the fraud and minimize the damage?
Consider the case of former hedge fund manager Samuel Israel III, who was convicted of running a $450 million Ponzi scheme and was sentenced to 22 years in prison. Israel gained additional notoriety in the summer of 2008 when he rather clumsily faked his own death to avoid prison. After two months on the lam, Israel turned himself in and is now incarcerated in Butner Prison in North Carolina—the same facility that holds Bernie Madoff.
Israel started his Bayou Hedge Fund Group in 1996 during the roaring bull market for dot-com stocks. He quickly raised several hundred million dollars from sophisticated Wall Street investors. But when the firm lost much of that money on bad trades, Israel began producing fake statements and performance reports, confident he could recover the losses later. That didn’t happen—but the lies didn’t stop.
Why was Israel so dangerous? Because he’d established relationships with investors who entrusted him with their assets when he was still providing ethical advice and services. His clients had been lulled into a false sense of security.
Israel appears to have had a change of heart since going to jail, and recently told the New York Times’ Andrew Ross Sorkin that “everyone cheats” on Wall Street. Maybe, if you expand the definition of cheating to include behavior that’s legal but ethically dubious. Investment banks turn huge profits doing what is best for them versus what is best for their clients. Wealth managers sell high-priced products that underperform the market because they get commissions for doing so. Wall Street spends millions selling an image of trust and competence even as it spends millions more fighting disclosure and fiduciary standards. You have to be willing to step up and protect your own financial interests because Wall Street and the regulatory agencies won’t do it for you.
Israel recommended three types of due diligence that you should practice if you’re willing to take on this responsibility. First, investors should require full transparency from financial advisors. No information about advisors—including experience, education, certifications, licensing, fiduciary status, compliance records, performance, investment expense and compensation—is too sacred to be disclosed.
Second, avoid black box investing. Black boxes are gimmicks designed to gain control of your assets. Investors are told they will never understand the complexity of an investment strategy, which is why it works—if everyone understood the black box, they would all be using it and it would no longer work. Sounds plausible, but most of the time the black box is really just a black hole. Do not invest in any product or service that you do not understand.
Third, always visit a firm’s office and meet the staff before you invest. Fictitious staff is a common element of many frauds. (Fictitious offices too, sometimes.) A visit to the primary office will usually uncover such fakery.
I’d add one caveat to Israel’s recommendations: Watch out for investments that are too good to be true. Only in the sales pitches of dodgy advisors will you find high returns for low risk. Also, be skeptical of performance reports about a fund or a wealth manager who never has a bad year. Sooner or later, everyone has a bad year. Everyone honest, anyway.
