and How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Press)
Ken Fisher Interview Part 3
Stockerblog: Let's talk about keeping your assets separate from the money manager. I know that's one of the major issues to keep in mind when you invest. But doesn't that really preclude an investor from investing in a private equity fund, a real estate limited partnership, or hedge fund, where once the money goes in, it's under their control?
Fisher: You are largely correct. Not completely, but largely. For the most part, most entities that are in the business of effectively being a hedge fund for their own convenience tend to set things up where they take custody. Whenever you give someone physical possession of your assets, you are trusting them completely not to take it out the back door. So to the extent that they are a private equity firm or a hedge fund and there is not the separate third party custodian, you always run the risk of being embezzled. There is no exception to that.
So that is something that people don't think about because they prefer not to, but it is exactly how people got nailed by Madoff, and exactly how people get embezzled by every Ponzi scheme, embezzler, ratzo, and con artist. In fact, it's how Madoff hurt himself. The fact is, if Madoff had set himself up originally to have a separate third party custodian, he never could have fallen to the temptation to dip into the till, which by his testimony is what he did.
I want to reiterate that this man, before he started down the path of criminality, was a very successful businessman, very wealthy in his own right.
In the book, How to Smell a Rat: The Five Signs of Financial Fraud
, I talk about how people fall into this one of two ways. Like Madoff supposedly did, they happen out of convenience where they take custody and then run into a bad patch, and they need some money so they dip into the till. They usually see an investment opportunity that they're sure will pay well enough to both give them the money they need and replenish the money for the investors that they took out of the till, and then they put the money in that investment, the investment goes sour. Now they dig in one more time to the investor's money, dig deeper, make a bigger bet, it goes sour, and now they are in the hole far enough that they can't pay back the money they originally planned to pay back, and they go into perpetual criminality, which is what happened with Madoff.The other side of the coin is, people in my opinion who are like Alan Stanford from the beginning, set up to be a criminal and used this vehicle, the notion of taking fiscal custody, as a way to scam people as an intent from the beginning. I don't know the proportions but I would say two thirds are people that set out to do the criminality and one third are people who from convenience just fall into it.
But this is one of the reasons that when I set up my business, at first, I made sure that I could never take custody because it protects me from myself. It protects me from a weak moment. It protects me from some bad employees. The fact is, I'm not only protecting my clients that way, but I'm also protecting myself that way. In my view, when you have your listeners (and readers) thinking through, is the extra return worth it, to go to some particular exotic form of investment where they get custody of your assets, you have to trade in your mind that somehow the extra return that you think you are going to get against the risk, that at any point in time along the way, you are always vulnerable to embezzlement if you do that.
Stockerblog: I know that some investors go into real estate limited partnerships for the tax benefits and other types of partnerships. So they don't, other than doing as much due diligence as they can, they don't have much choice once they turn their money over to a limited partnership.
Fisher: Once you turn your money over to someone else, they can take it out the back door.
Stockerblog: So do you recommend that people avoid the more exotic forms of investments and limited partnerships?
Fisher: I think you have to think of the extra risks involved. You have to say to yourself "How much of my money do I want to put into this, where I end up with this extra risk". It's the extra risk of losing everything. For the most part, one of the dilemmas that we see with these Ponzi schemes and con artists is that they convince people to put in a third, two thirds, to all of their money. It's amazing to see how many people had Madoff as their primary investment, effectively wiping them out almost completely. If you are going to put money in one of these things where you think you are going to get a higher return, but there's also the possibility of embezzlement, you don't really put that much of your net worth into it. You want to think of it more like you are putting your money in a stock.
Stockerblog: In one part of your book, you talk about how bad performance does not necessarily mean that the manager is a rat. As a matter of fact, its probably more likely that they are not a rat. Can you discuss that briefly?
Fisher: Sure. Anyone that's been in the investment business for a very long time, I don't care if it's Warren Buffet, Peter Lynch, Bill Gross, I don't care who it is, everybody's had bad years. The nature of the beast is, if you're around for a long time, you've had bad years. The honest entity, the non-con artist, the non-ratzo, isn't concerned about exposing his bad years to the public because they take it for granted that it is part of the natural course of evolution that you're going to have these bad years.
Now, one of the points that I make in the book is I say "Show me the whoppers. I want to see your bad years. If you don't have any bad years, there's something wrong here." One of the central points in the book is that every Ponzi scheme embezzler always claims returns that are too good to be true, and aren't true because there really isn’t any investing going on. When you see returns that are too good to be true, they probably are. What the con artist knows and the reason the con artist never shows a bad year is because they know that as soon as they show a bad year, it will motivate a potential investor to ask questions. The con artist doesn’t want anybody asking questions.
One of the natures of human existence that I think all of your listeners (and readers) know is that people don't like volatility. They like a smooth easy ride. When the con artist shows that every year is a good year, it tends to make people not ask questions, it tends to make them more calm, it tends to make them think, "Boy, this guy's really a genius." Where in reality, the person that's a really good honest investor has always had bad years, so whether it's Warren Buffett or whoever, you say "Show me the bad years" as a form of proof statement about your integrity, so that you know that everything won't be perfect in the future and there will be a lot of volatility, but I know this guy is not a con artist because every con artist ratzo that does this embezzlement, they never show a bad year.
End of Part 3 – Stay Tuned for Part 4
If you missed Part 1, you can check it out here
If you missed Part 2, you can check it out here.
By Fred Fuld at Stockerblog.com
Copyright 2009. All rights reserved. Reproduction of this interview prohibited with out permission. All opinions are those of Ken Fisher, and do not represent the opinions of Stockerblog.com or the interviewer. Neither Stockerblog nor the interviewer nor the interviewee are rendering tax, legal, or investment advice in this interview.
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