Saturday, April 9, 2011

How To Smell A Rat: Chapter 5

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 final piece of advice from Fisher on the subject of avoiding frauds is for investors to do their own due diligence. He acknowledges that it is tempting to look for shortcuts. Many people make investment decisions by relying on friends or people in perceived positions of authority. But such people have increased the odds of getting duped by a rat. One of the reasons fraudsters target people belonging to affinity groups is that they are more likely to accept the recommendation from another member of the group and assume that the due diligence has already been done, rather than do their own.

In order to conduct due diligence, investors also need a fund that offers a decent level of transparency. For this reason, Fisher advises against investing in feeder funds or "funds of funds". Not only do these setups have a bunch of extra fees, but they also add a layer of obscurity, making the due diligence a lot more difficult.

SEC-registered firms are simpler to vet. These companies are required to disclose certain information, and are subject to random checks. However, SEC registration does not guarantee that a fund is not a fraud. The SEC staff is simply not equipped to be able to find all frauds before some investors get duped. Fisher gives the reader a rundown of the various forms investors should read and what they should be looking for.

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