Saturday, October 27, 2012

Beware of Serene Ducks


Beware of Serene Ducks

Imagine spotting a duck swimming serenely in turbulent waters.  You might say, “That’s one amazing duck.  How does he do it?”  You’d be even more astounded if all the other ducks were struggling to stay afloat.  If the duck were an investment manager, you’d be attempted to give him all of your money to manage.  Moreover, the rating services like Morningstar would most assuredly assign the duck five stars.  After all, this investment duck is something we all dream about for our retirement savings or our favorite endowment’s investment fund.  We want an investment that will rise in value, without inducing the nausea that comes when the financial markets become unstable.
Fund Launch (1999)

As I mentioned most people are immediately drawn to this miraculous duck for their investment portfolio. In fact, most investors not only make commitments to this type of investment, they tend not too pay much attention to it once the money has been committed.  If the money manager is producing consistent returns in unpredictable markets, he must be one of your winners.  Most investors focus all of their concern on the mere mortals who are producing inconsistent or even poor returns during volatile periods.  The instinct to ignore the outstanding manager and focus on the laggard is completely wrong, and gets investors into deep financial trouble. 

When an investment sails through volatile markets without bobbing, investors should become highly suspicious rather than complacent.  This is the very investment that should keep you up at night.  Something is going on beneath the surface to make that duck defy the laws of nature and investments. 

Unless you are prepared to do a great deal of investigation, you should always avoid an investment that offers attractive, steady long-term returns with very low year-to-year variation.  It is going to be hard to resist making the commitment, because brokers and advisors are going to say that the manager of this investment product is absolutely brilliant.  Matter of fact, you should tune out any investment pitch in which someone is claiming that a money manager is a genius.  You are also going to be wooed by a claim that this is a limited or even rare opportunity, and that only a few chosen investors will get to invest with the duck.   By now you will be trembling with excitement as you reach for your checkbook to invest in this outstanding, low risk product managed by an investment “wunderduck.”  Put your checkbook back in your pocket and walk away.

At its worst, this duck is a complete fraud like Bernard Madoff.  However, it’s also entirely possible that the duck is a legitimate investment feigning stability, and is, in fact, filled with esoteric derivatives that are eventually going to result in the duck drowning altogether and taking your investment with it.  On very rare occasions, you might actually hit upon this perfect duck, as for brief periods of time a money manager may produce consistent returns in volatile markets.  The reason you should stay away, however, is that it is nearly impossible to differentiate the legitimate from the illegitimate.  The legitimate is extremely rare, and seldom marketed to non-ducks.

Take the most egregious case of a fraud.  In almost every fraud the money manager manipulates the accounting system that prices securities and delivers investment reports to you.  So on the surface, the performance looks good, and there may be lots of details (trades, analysis, commentary) to back up the report.  However, beneath the surface, the manager is going to be furiously paddling his little webbed feet to keep himself afloat.  The task of the investor is to get beneath the surface of the water, because the feet are a dead give away.  The problem is that the duck is going to do everything possible to keep the investor from plumbing the depths.

Amazingly, most investment frauds don’t start out as such.  Typically the manager delivers legitimate performance or even superior performance.  However, after a time, things start to go wrong, and the manager doesn’t want to confess his sins to his investors.  So he begins to manipulate the accounting system, and thus the losses in your account aren’t apparent.  As long as you don’t ask for your money back and/or new investors continue to commit new money to the manager, he will be able to perpetuate the fraud. 

However, if new money stops flowing into his funds, and someone asks for their money, the manager has got a problem.  He needs to pay them based on the accounting statements, which say that they made a steady return, even though he has sustained losses.  Once he pays them, he has even less money available to cover what you believe are the steady profits in your account. So when you eventually ask for your money back, he’s got a huge problem, because he can’t cover what the accounting statement says he owes you.  All of a sudden and without warning the serene duck is a dead duck, and so are you. 

In the next post, we’ll look at a real example of the serene duck, and how it can be uncovered.

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