The worst investor fraud since Bernie Madoff appears to be upon us. Yesterday, managers at the New York based hedge fund Platinum Partners have been arrested as federal prosecutors allege the occurrence of a $1 billion fraud. Mark Nordlicht and has partners spent the last decade giving their investors nearly 20% annual returns, with those returns being fueled through return of other investors’ capital in response to withdrawal requests rather than actual investment returns.
Although the Platinum Partners clients may be able to receive some recovery through a combination of SIPC, insurance, and the distribution of remaining assets, this remains a worst-case nightmare for those who entrusted a meaningful portion of their accumulated savings to the stewardship of the Platinum Management team.
For the millions of Americans who have financial advisors, the natural follow-up inquiry is: How can I prevent my family from falling victim to the fraud of a Bernie Madoff or Platinum Partners type?
It is difficult to police the management of your assets because there is an enormous information asymmetry between what your financial manager knows and what you know. What is that Japanese cooking style where you see the food cooked in front of you? Teppanyaki? Hibachi? Yeah, this isn’t like that.
Often enough, you can’t verify exactly what your financial advisor is purchasing on your behalf or the rationale that goes beyond it. Fiduciary laws rightly define the advisor-client relationship as a relationship of “inherent trust and confidence” because clients rely upon the honesty of financial advisors to be truthful in the information that they provide to clients.
Despite some limitations created by a lack of proximity and access to the information, there are two steps that an investor can use to ward against fraud.
First, you can insist that all trades be placed through a major brokerage house tied to your name or a global custody arrangement that ensures the financial advisor’s trades are in your name. Most importantly, it prevents the financial advisor from gaining exclusive control of the asset which is where fraudulent troubles arise. You can’t fool a brokerage house because it, by definition, is making the trades that require an asset exchange through The Depository Trust & Clearing Corporation. You can’t fool it because someone on one side must be receiving 100 shares of Colgate-Palmolive (CL) and someone on the other side must be receiving $6605.00 as their consideration for relinquishing their ownership of the asset.
The second step, and this is the difficult one, you must refrain from wilful ignorance. Business students should get the phrase “Beware of smooth high returns” tattooed across their biceps. There are too many people out there who want to see their capital inch forward a little bit each month and then show 10% or greater returns at the end of the year.
In the case of Platinum Partners, they made significant energy investments.
The Wall Street Journal articles “Authorities Allege $1 Billion Fraud at Platinum Partners” contains the following piece of information:
“Platinum’s then-president, Uri Landesman, who was arrested Monday, coined a phrase for the moment. As he urged investors to stay put, he sent a note to Mr. Nordlicht, saying “Hail Mary time,” according to the SEC. Platinum was desperate to keep its investors calm, because Mr. Nordlicht was doubling down on hard-to-sell energy investments despite a steep drop in the price of oil, according to investor documents and people close to the firm. The federal complaint described how Platinum kept the valuation of some suchholdings steady in face of evidence that they were close to worthless.”
Superior returns without intervals where the investors experience drops in the net value of their investments is a red flag so big you could hang it off a building. This is especially true when commodities are involved.
I remember in January 2015 when I wrote the article “Chevron Below $100 Per Share Is Blue-Chip Value Investing.” My view is that investors were getting a good risk-adjusted deal at any point below that price range. Guess what happened? Before paying out an additional $8.56 per share in dividends and reaching its current price of $117 per share, Chevron’s stock price went all the way down to $75 per share. You lost a quarter of your value with one of the three highest quality energy firms in the entire world.
If an aggressive fund is investing in small cap oil stocks, you should be losing around half of your value in pursuit of those 15-20% annual returns. That’s their tradeoff–you accept big volatility and hope to get rewarded with big returns. And yet, Platinum investors experienced minimal volatility while receiving annual returns in the 15-20% annual range. I don’t know how you can get returns that high in the commodities sector without pointing to blips along the way where you’re like “Yep, I was down 40% there. I had to channel St. Lawrence getting burned at the stake when he said ‘I’m done on this side you can turn me over’ during those days.”
Smooth returns that greatly outpace the S&P 500 over long periods of time deserve scrutiny. If these returns occur while your money is being invested without the conduit of some kind of brokerage intermediary, your scrutiny should be turned up to the tenth power. Wariness is deserved when a passive fortune is created quickly without any required tradeoff along the way.