Sunday, March 27, 2011

How To Smell A Rat: Chapter 2

Recessions seem to unearth a great number of financial frauds. But by then it is usually too late, as investors end up losing most if not all of their money. In this book, value investor Ken Fisher (son of Philip Fisher, whom Warren Buffett cites as someone from whom he learned a great deal about investing) describes five ways ordinary investors can protect themselves from being duped by a fraudulent money manager.

The second sign that Fisher warns investors to watch out for is a track record of consistent and high returns. Ponzi schemes (which is the method of choice for fraudsters looking to get rich quick) can't afford down years, because this causes investors to pull out capital. When capital is pulled out of a Ponzi scheme, the scheme collapses. (Investors also pull money out of funds during recessions, which is why Ponzi schemes tend to be uncovered during recessions.)

Therefore, fraudsters literally can't afford to report down years, so their track records will always look consistent. But Fisher argues that real money managers have returns that are highly inconsistent, even the great ones. All managers have a few flop years, where they badly underperform either absolutely or relative to the market. But only the honest ones will show it; a Ponzi schemer will have no such blemish on his record.

Fisher advises that investors look at a manager's past performance and ask for the fund's benchmark. Look for some correlation between returns of the fund and those of the benchmark, and if there isn't any, be afraid! At best, the fund isn't even employing the strategy it is marketing to you, and at worst the numbers are totally made up.

Also, look for the years where the fund underperformed, and ask the manager what happened in those years and what he learned from them. Only if the explanation is reasonable and makes sense within the context of the fund's strategy should the investor proceed.

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