In its broadest form fraud is more common than many realise. It can be present at any stage of a market cycle and often leads to total loss – unlike market crashes which eventually recover.

Of course, in the real world defining fraud is sometimes difficult. Investments can fail because of bad structure, excessive leverage or flawed strategies, but are these frauds? Consider some of the overly hyped, complex and leveraged structured products that failed through the GFC.

Was Storm Financial, an advisory group that encouraged extreme double leveraging into index funds in the lead up to the GFC, fraudulent or simply a victim of a market crash? One could argue it was fraudulent in that it encouraged a strategy that was certain to blow up when the inevitable major bear market came along, and that likelihood was readily apparent to any finance professional who did the maths.

Others might argue Storm was just incompetent but never lied or intended to trick people. This highlights that there is a significant grey area between incompetence and fraud. Indeed, incompetent but presentable people are sometimes attracted to the fraud path.

Avoiding frauds and scams

Large investment organisations can afford to employ individuals or external consultants who can undertake detailed operational due diligence to identify fraud and fraud risks in a particular investment. Smaller investors and advisers can do some basic checks such as ensuring reputable service providers are used and the background resume of key people, but this can still fail to identify a well-constructed fraud.

In practice, the ideal defence against fraud is extensive experience in a range of investments, seeing how various frauds occur and developing a network where you can check the reputation and experience of people in a reliable way. Using this experience, one can attempt to identify some of the common characteristics of fraudulent products and those less scrupulous participants in the financial services industry and develop a range of heuristics or red flags to be on the lookout for.

Some of these red flags might include:

  • An investment strategy that sounds too good to be true in terms of returns or low volatility.
  • A reluctance of the promoters to discuss deeply the specific investment strategy, preferring to talk about broad investment themes and producing shallow investment commentary.
  • Lack of transparency of the underlying investments and the valuation of those assets.
  • A mixed work history of the key people involved or an inability to find out much about that history. People rarely change their core character although some scammers do regularly change their name.
  • A domineering, even ‘cult like’ leader, often with excellent communication skills who is largely immune to criticism from associates or clients.
  • Flashy office fit-outs and an extreme sales focus.
  • Lack of true independent assessments of the investment, instead relying on conflicted or shallow reviews.
  • A tendency to hire prominent ex-politicians, media personalities or celebrities in promoting the business or investment product.
  • Frequent changes in external auditors, CFOs or other key financial positions.
  • A tendency to quickly call in the lawyers, or make threats to do so, in response to criticism.

In my view, advisers and investors need to develop a habit of thinking more sceptically about investments and people.

There is an increasing amount of information that can help educate one on how frauds and scams operate and help with identifying red flags such as above. ASIC’s Moneysmart website has some useful tips covering investment and non-investment scams. However, nothing beats learning from real life case studies.

A fascinating recent fraud in the US is that of biotech company Theranos, whose founder Elizabeth Holmes claimed to have found a new, more convenient way to test blood which turned out to be false, leading to the company’s collapse. The gory details are revealed in Bad Blood: Secrets and Lies in a Silicon Valley Startup, by journalist John Carreyrou, and a new documentary by Alex Gibney called The Inventor – Out for Blood in Silicon Valley.

Local markets not immune

Don’t expect an ASX listed structure to protect you. While fraudulent and less ethical activities in operating companies are expected from time to time, problems can also occur in listed investment vehicles.

While frauds are probably more common than most think, they are still relatively rare in the context of the number of investment products and offerings available. But because frauds can be so devastating, the impact on individual lives and households can be dramatic. Therefore, spending some time developing a basis for ‘fraud proofing’ a portfolio makes sense.

I am not sure the Hayne royal commission has done much to lessen fraud in the future, except perhaps in the area of excessive leverage/irresponsible lending.

Perhaps younger generations are better placed to avoid frauds because of their natural scepticism about almost everything. However, while these younger generations are sceptical and less trusting, they also seem to consider themselves smarter and more tech savvy than average, and yet seem willing to trust someone or something positively spruiked on the internet with little consideration of from where such views derive or the significant conflicts often involved in generating them. Certainly, the internet has been a goldmine for those looking to structure and promote frauds and scams.

It is concerning that more investment frauds and scams seem to be coming to light, even though the economy and financial markets have generally been doing well.  If things are about to get tougher for both, we can expect to see more frauds and scams exposed in coming years.  Perhaps then we can expect that avoiding frauds will be a more prominent focus of investment selection and management.

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