Crooks' Common Threads: Three Red Flags to Watch Out For

A crooked Minnesota adviser bought a getaway car not unlike this one with part of the $10 million he bilked from friends' portfolios. Source: Bloomberg/Getty Images.

These days, it seems headlines are full of one investment scam after the next. Weren't these supposed to die down after the Bernie Madoff scandal made the world hyper-aware of financial fraud? We sure hoped so. Yet, sadly, investors are still getting duped six years later. Perhaps the saddest part of all is protecting yourself against criminals and charlatans is fairly simple if you know what to look for. If you're familiar with three basic signs of fraud, you can easily avoid being a victim.

We've seen several scams in the past couple weeks. A Boston adviser misled clients of his old firm into transferring their assets to a new brokerage firm he started-then jacked up their fees. An ex-MIT professor and his son ran a hedge-fund scam and took off with $12 million, robbing clients of 50%-75% of their initial investments. A broker from Virginia stole $730,289 from elderly clients and sent them false monthly statements purporting to document their investment progress. And perhaps the raciest of them all: A Minneapolis financial planner stole at least $10 million from clients through a Ponzi scheme-and allegedly blew it all on vacation homes, a pleasure boat, a 1968 Camaro and Vegas bacchanalia.

For folks who knew the signs of fraud, these scams would have been relatively easy to spot. Each violated at least one of the big three financial fraud red flags:

• Red flag #1: Advisers take custody of clients' assets.
• Red flag #2: Advertised returns are too good to be true-all up, no down, steady regardless of what the market did.
• Red flag #3: The strategies are complex, murky and full of jargon and meaningless buzzwords.

All four shysters took custody of their clients' assets. Two hit the trifecta. The professor and his son promised 16%-23% returns annually (with no down years) and used a "complex mathematical trading model." The Minneapolis slime ball promised a steady 10% or so annually and used unintelligible jargon to communicate his strategy.

Knowing how these factors enable fraud is the key to protecting yourself. Let's start with custody. If you give an adviser custody of your assets, you're giving them your money. It's a bit like handing some guy on the street a wheelbarrow with a million bucks and asking him to watch it while you pop in for a cup of coffee. He can run off with it. Some advisers act ethically but others-like those listed above-don't, and it's a huge risk to take. If you only work with advisers who separate asset custody, you aren't exposed. Keeping your money in an account in your name at an unaffiliated third-party custodian prevents a crooked adviser from reaching in and taking what he or she wants. You can keep tabs on your holdings with regular statements and online access. Statements from a trusted, third-party source-not phony-baloney statements like the Virginia broker sent her clients.

The evils of advertising too-good-to-be-true returns might seem obvious-they'll attract victims! But it's more sinister than that. It's a way for advisers to weed out people who would naturally be more discerning and inquisitive. If an adviser tells an investor, "You will receive 15% returns annually," and the investor responds with a "Are you crazy!? That's impossible! Markets don't work like that!" then the adviser knows the investor is too smart to hoodwink, and he moves on. Anyone who has the savvy to question that claim probably also has the smarts to question some other things. Like whether those returns come from actual growth or money funneled from new clients. Advisers don't want clients who can smell fraud! They want investors who don't ask too many questions. Those who don't challenge advisers and call them out on their lies. The New York Times documented a pertinent example recently: Nigerian scammers paid for Madoff's client list and launched a sham website claiming to have retrieved $1.3 billion in losses, promising to return the money if victims sent their account information. You know what comes next-they stole even more of those poor folks money! They created an affinity that targeted people who'd already fallen prey once on the notion they might again. So remember: if something is too good to be true ... it usually is. Returns vary. Markets are volatile. There will always be good years and bad.

Finally, jargon. Fraudsters use it to impress and confuse their victims-they know folks who don't ask them to explain things in simple terms normal humans can understand will be trusting enough to enable their scheme. Anyone who knows options would know Madoff could never get 10% a year with a split/strike strategy. But most of his clients didn't question it-it sounded smart! Financially! Wall Streety! One client of Mr. 1968 Camaro said, "After meetings I would say to my husband, 'Do you know what he was talking about?' And Mike would say, 'Not really. But this is Sean, so I'm sure it's all fine.'" But it wasn't all fine, and it turns out Sean-someone they thought was a family friend-wasn't worthy of their trust. Investors should be able to understand what they're getting themselves into-and an honorable adviser would want them to. They should be able to understand exactly how the adviser plans to get the return they need to reach their goals and assess whether the strategy is realistic. If you don't understand something, ask questions. And if they can't or won't translate jargon to human for you, that's a big sign.

Scam artists will always be on the prowl. But that's why it's important for folks to look for advisers who put investors first-advisers who don't custody their clients' assets; advisers who align their interests with their clients'; advisers who value transparency and believe they have a higher purpose to guide folks to their long-term goals and objectives.

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