The number one, biggest, reddest flag is when your adviser also has custody of your assets, cautions Ken Fisher in ‘How to Smell a Rat: The five signs of financial fraud’ (www.wiley.com).

No matter how goofy the strategy or tactics, if the adviser can’t get to the money, you know they aren’t using them to create a false front for fake performance while carting money out the back door, he explains. “A goofy strategy may not be so optimal for your future, but I’d much rather have a goofy but honest adviser than a really smart rat.”

And as long as no one’s Madoff with your money, you still have assets and a fighting chance for the future because you can get rid of a goofy but honest adviser and replace him with a better one, reasons the author. “But you’re still living under the principle that sometimes the return of your money is more important than the return on your money.”

Just because Bernard Madoff is safely behind bars, don’t assume the world’s now safe from his brand of disaster, Fisher instructs. Though Madoff and R. Allen Stanford were big news in 2009, this kind of scam is nothing new, he adds. “History is littered with rats, big and small, who helped themselves to client money – whether the clients had millions or a few thousand. Madoff made headlines because of the scale and scope of his long con, but what he allegedly did – a Ponzi scheme – has been around since long before Charles Ponzi gave this con a name in 1920.”

So how can you rat out a rat? By knowing how they operate, the author guides. No matter what the window dressing, no matter the psychological ploys, the rat’s fundamental operation is the same, he notes. “They sell themselves as chief decision maker. Then they have clients deposit assets in a custodial institution they control or in an account they control - allowing them to plunder at will.”

The second sign of fraud is that returns are consistently great, almost too good to be true! “Someday, a rat will figure out how to package a return display that includes bad years to fake integrity while somehow packaging it so it doesn’t scare fearful investors away; but it hasn’t come out of the woodwork yet.”

Great, non-volatile, consistently positive returns keep the victims ensnared and docile; for, ‘who complains about returns that are big, no matter what the market does?’ As the Ponzi runs its course, new money pays off the fewer older investors who redeem. “The fake high return keeps attracting new money, new victims, new suckers – all sizes. A fraudster skilled and charismatic enough can avoid detection for years, compounding losses, creating a wider victim web.”

The third red flag is up when the investing strategy isn’t understandable; it is murky, flashy or too complicated for the adviser to describe so you easily understand! Not admitting you don’t understand may save your ego, but it can eliminate all your money, Fisher advises.

An example of inscrutable strategy cited in the book is from a 2001 Barron’s article, sourced from Madoff’s marketing materials, thus: “Typically, a position will consist of the ownership of 30 to 35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio’s downside!”

This is no underlying strategy, it’s just a lying strategy, Fisher fumes. “If a strategy or tactic confuses, don’t assume the manager is smarter. Assume they either can’t explain themselves well – a bad sign – or it’s something more sinister – a quite terrible sign.”

Imperative read.

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