Within the past four weeks, two news stories have broken about Indianapolis area investment firms being charged with fraud. Follow these links to read the stories of JCL Capital and Veros Partners.  We want to point out that none of the principals involved have been convicted of wrongdoing, but the charges naming them are serious and therefore troubling.

Investment managers are no more inclined to be dishonest than people in any other profession, but the nature of the work means losses from fraud are often life-altering for clients. Regulators work hard to make sure that criminals are prosecuted, but full financial restitution for victims of fraud is often impossible. Ultimately, investors are responsible to protect themselves against loss.

Caveat emptor – check. But exactly how can buyers beware? We think the following “red flags” can help alert investors to the potential for financial disaster:

  1. Sphere of Competency. Investing well is a full time job and requires years of training: check credentials and experience. A former stockbroker opening up a hedge fund, and a CPA firm bolting on private investment funds, are practices that ought raise questions. An analogy from medicine may help: if you broke your ankle, would you consult an oncologist?
  2. Separation of Powers. One of the key problems with private and illiquid investment funds is that the role of the investment manager is merged with the role of account custodian. When investments are held in custody by one reporting entity, and managed by another entity, investors have an added degree of assurance that what’s being reported is what’s actually being done. Ponzi schemes, in particular, are much harder to execute if the fund manager is separate from the account custodian.
  3. Fee Transparency. We’ve written repeatedly that investors should demand investment fees that are reasonable and easy to understand. Any degree of complexity – from Class “C” mutual fund shares, to annuity surrender charges, to performance incentives in hedge funds – is worth taking the time to understand better. Know how and how much you pay your investment manager, and make sure they report back to you about the commissions or fees you pay.

If your prospective advisor passes these tests, be sure to learn more about them and their firms from trusted third parties. Personal references may work, but professional references – from CPAs, attorneys, other investment managers, etc. – carry more weight. Also, the Securities and Exchange Commission and the Financial Industry Regulatory Authority maintain databases of investment advisor and broker records.

For all parties involved, we hope the open cases referenced above turn out to be nothing, and that clients weren’t intentionally harmed by their financial advisors. Human nature being what it is, though, we know that there will be other advisors in the future who choose to cheat their clients, and the best defense against this is an informed investor.