Identifying a Ponzi Scheme - The Nugget of Glass in a Bowl of Diamonds by:Dominic Mazzone

. As a fund manager of an extremely transparent fund, there is nothing that brings out more fury in me than a few bad apples scaring people to a point of not even wanting to put their hand in the barrel. Sure Madoff is the poster child, but there are a host of others that have created schemes of the Ponzi sort that are equally as devastating to the people invested in them.

Now Stanford Financial is being accused of misrepresenting the safety and security of their C.D. offering while also providing returns that the SEC is called in its filing "improbable if not impossible". In other words, they are saying it's fraud. In the midst of all this fraud, we are seeing fingers pointing the blame at every government regulatory body possible; we are hearing a battle cry for some sort of protection through regulation. I do believe that the creators of these fraudulent schemes should meet the firing squad, but it's important to understand that the people investing in these schemes really didn't understand the investments in the first place.

In Madoff's case, he was creating such a complex illusion, that unless you were in the business you wouldn't understand that it was all a lie. We are reading all kinds of accounts where Madoff's investment strategy even had many fund managers in the industry baffled. Some of these managers were smart enough to know a black hole when they saw it and walked away. Others either figured Madoff was a genius and you shouldn't ask to fix something that you thought wasn't broken, or they were so intimidated by him that they thought too many questions would have either insulted him or made themselves look foolish.

There is nothing like admitting when you don't know something and for example, I have a pretty good understanding of the stock market but not enough of an understanding to invest heavily in it, and therefore I don't. I do have an understanding that commodities like precious metals and oil are limited, so the natural economist in me understands the long term supply and demand story. Again, if I understand it I invest in it, and if I don't I won't. It may seem like an elementary philosophy, but one that has made and saved investment dollars over the years.

What is on everyone's mind right now is how you can tell if something is a Ponzi scheme or just plain fraudulent. There have been all kinds of opinions on this and like most knee jerk reactions they are not very rational. I thought it would be helpful for all of us to re-examine some fundamental considerations when weighing an investment opportunity.

Track Record: A fund manager's track record, in most cases, gives a history of performance and the appearance of being reliable. The question is whether or not you can you identify if a fund or its managers are on the up and up from their track record. Madoff had a pretty good track record and he used the confidence built from that track record to deceive people. I do agree that a track record is a valuable gauge when tempered with other qualifying factors, but it is not the end all be all of litmus tests for trust.

Fund Structure: Everyone is up in arms because Madoff wasn't a registered investment advisor. You would have to have 1950's style innocence to believe the government would somehow have discovered his deception all because he was registered in a bloated government database. Whether he was registered or not, he was still going to deceive people and he was still going to get away with it for as long as he did. Government registration of either advisors or funds doesn't mean anything. The government allows for a Regulation D filing that permits private investment funds not to be registered with the SEC. Before you go and start writing your congressman to ban all private funds, you might want to stop typing. Gauging integrity based on whether a fund is private or public is a pretty nave view when you consider we have had Enron, Worldcom, Subprime Mortgage Backed Securities (MBS) rated AAA, and a whole host of other world class schemes that have taken down not only their shareholders, but in the MBS case, it has now taken down the global economy. Remember, these were all publically traded and not private. In the Stanford scheme all of the Stanford companies were either licensed or registered in the United States. So much for the government registration theory to gauge investment safety.

Appearances: The old saying goes, believe nothing that you hear and half of what you see. Just because something looks or feels legitimate, doesn't necessarily mean it is. Madoff had what appeared to be a mini trading floor and this was probably created to put any investor concerns to rest. Though if you speak to anyone in the business they will tell you that most trading floors are about as big as a football field and packed with frantic people. For my taste, the last thing I would like to see in any investment strategy is an excessive amount of overhead that needs to be paid for by either investor returns or higher risk strategies. The thought of a giant office in a prestigious part of town, or a building with a logo on it makes me cringe when I think about the costs. Again, as an investor you always need to consider how all of these overhead costs are going to be paid for. Take a look at the many hedge funds that are now defunct because they were not only suffering huge losses in the market, but their overhead never changed, and their only choice was to close up shop. Getting back to sound economics is what you really should be looking for in an investment fund instead of corner, glass office.

Independent Auditor: I can see the benefits of having an independent auditor, but it is another issue when the auditor is possibly in the back pocket of the fund being audited. In Stanford's case, the independent auditor was in Antigua, and though I am not well versed on the auditing sector, I have a sneaking suspicion that Antigua is not a hot bed of precise auditing firms. I would argue that an independent auditor is a god idea in many cases, but who do you end up choosing for the independent auditor? There just seems to be a barrage of unethical behavior even from some of the largest firms. For instance, the UBS case in which they have admitted to conspiring to defraud the Internal Revenue Service by helping investors hide money in Swiss banks. An institution of this size must surely have had one of the best independent auditors in the business. The problem is that you only get to audit what you have access to and can see. I am guessing nobody at UBS handed the auditors a book and said, "Oh yes, this is the Illegal Swiss Bank Account Ledger for US Citizens."

Exclusivity: I think this is the portion of the Madoff story that creates an inordinate amount of head shaking. Nothing like using an elementary school tactic of telling people that you don't want to be their friend which in turn makes them want your friendship even more. Take this into the adult world of investing and think about the psychological aspects of an investor going into an investment agreement with Madoff. The interviews of burned Madoff Investors talk about how it took persuasion and references to get Madoff to consider taking new investors on. By the time the investors were ready to invest, they were already feeling that they were lucky Madoff was even going to allow them to invest. This ends up causing a lack of questions being asked in a "don't bite the hand that is going to make you huge returns" kind of way. These investors had the psychological deck stacked against them from the beginning, and then in a typical Ponzi type of way, brought more investors in under the same conditions.

Understanding the Model: Western culture celebrates and marvels at genius, and this type of mentality has really helped professionals like doctors create their famous "God complexes". However when it comes to being sick, I am just fine with the God complex since most of us understand money better than we understand medicine. Financial instruments no matter how complex come down to one very basic premise. I invest money, and I am going to receive that money back with some sort of profit. This is not to say that everything goes as planned, but every investment should be able to be followed from beginning to end to see how that profit and original principal is going to be returned. If you don't understand how the money is being made, then why are you comfortable investing your money? A lot of passive investors feel like investing with a money manager should be a Wizard of Oz experience and you should never look behind the curtain. Being a fund manager myself I am completely passionate about asking questions and I not only pull questions out of interested investors in our fund, but I ask questions for them. There needs to be an open dialogue anytime someone is investing your money and you should feel comfortable contacting them at anytime to ask any questions. It's what the job entails and if anyone tells you different, start running. But even before this you need to understand how they are actually generating the returns. During the summer of 2007, a childhood friend of mine kept telling me about the Agapi Fund being run my Nick Cosmos, and the tremendous returns he was receiving through them. Since the Agapi Fund was supposed to be acting as a bridge lender, which is the same model as my own Fund, I knew something was wrong because I truly understand how returns in this model are generated. Since the Agapi fund was promoting returns five times higher than our own fund, I kept telling my friend that these returns were not possible and he should ask for his investment back immediately since it sounded like an investment scheme. Some time after that conversation, Nick Cosmos was indicted on running a Ponzi Sceme and my dear friend is out $100,000. He didn't understand how the returns were being generated and therefore, he didn't understand how he was being deceived until it was too late. Transparency is security.

It's easy to see the moral of the story. There are no quick answers in identifying a fraudulent investment scheme and the typical answers are not always the right ones. The only thing that you can really rely on is your own common sense, and hopefully the above points help you organize that common sense in a way that creates an early warning detection system. Said another way, don't rely on your neighbor, friend, or even investment advisor to use their common sense for your best interests. It's like volunteering to let yourself hang off the edge of the Grand Canyon with someone else holding the rope.

About the author

Copyright: Dominic Mazzone, Regent Global Funds 2009

This article was written by Dominic Mazzone, Managing Partner and Fund Manager of Regent Global Funds.

This article and other like it can be viewed at http://www.investingsymposium.com which is part of the Regent Global Funds Network.

Regent Global Funds, http://www.rgfunds.com, is an alternative investment fund that offers its participating investors and asset backed investment through asset based lending.

The Fund Managers of Regent Global Funds have an expertise in commercial real estate lending and have created a successful alternative investment vehicle that is diversified through this structure.

They separate themselves from other fund mangers by personally investing their own money side-by-side with their investors in the fund, creating an absolute structure of accountability. Dominic Mazzone has written about the need for this type of accountability in an article titled "Fund Managers Need to be Accessible and Personally Invested"

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