Ponzi scheme - a con game in which the illusion of solvency was created by paying off early investors with capital raised from later entrants. As long as new investment continued to come in the door, the earlier adopters reaped fat rewards; once markets tumbled and investors withdrew, however, the whole thing collapsed like a house of cards. It trumpeted the possibility of massive gains, promised a high return in just 90 days by paying out the first few investors, and collapsed when the scheme couldn't rustle up enough fresh marks to keep up with the money going out the door.
In the wake of the $50 billion Madoff case, investors are looking at 'fund of funds' with some suspicion. As a former chairman of the Nasdaq stock exchange, Madoff had high level connections and credentials that kept many investors from seeing or regulator from taking seriously the complaints against his companies. Had investors delved deeply into his activities, they would have seen his businesses were not as squeaky-clean as his resume would suggest.
If the rich, famous and sophisticated can get bilked, how can you know whom to trust? Here are 5 red flags that should get your attention and get you ready for quick bailout.
The background check doesn't check out- The SEC and Financial Industry Regulatory Authority maintain publicly search able online databases of all investor charges, disciplinary actions, civil court filings, arbitration awards and bankruptcy proceedings involving brokerages and individual investment adviser. FINRA's Broker Check particularly helpful. It includes a summary that lets investors easily scan for any suspensions, disciplinary actions or consumer filings -- what the site calls "regulatory events" or "civil events." It also includes detailed reports outlining the specific actions taken.
You don't understand the strategy - SEC recommends investors ask a litany of questions, including several about how the company makes money. Investors should understand the company's strategy and how it relates to past performance. If the answers don't make sense, don't be afraid to keep asking what may feel like dumb questions.
Your manager makes a bundle even if you don't - Investment advisers should be paid by you. Otherwise, don't expect them to work for you. Advisers who earn commissions for selling certain financial products have a strong incentive to direct their recommendations to what makes them money, not what is best for your financial future.
No one else is watching the books - One of the reasons Madoff was able to avoid detection for so long was his company was answerable to few others. He was his own prime broker and auditor, meaning he was able to clear and settle his own trades through another arm of his company. Investors can protect themselves by ensuring that their investments must be cleared by an outside entity and audited by a large, reputable firm.
Your fund manager doesn't invest alongside you - Investors should ask just how much of their fund manager's wealth is tied to the fund's performance. If a mutual fund or hedge fund manager believes in his or her investment strategy, then his or her own money should be invested in the company. There are several ways to check the personal interest a mutual fund manager has in his performance. The SEC has begun requiring that fund managers disclose their stakes in their funds. Morningstar also analyzes funds based, in part, on how much the fund manager's personal wealth is tied to a fund's performance.
However, a personal stake by itself -- or lack thereof -- isn't a clear indicator. Some fund managers, such as those who manage employee pension funds or municipal accounts, may be barred from participating in the funds they manage.
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