I was watching an episode of American Greed on CNBC recently. The slick, fast talking con man was able to convince so many friends and neighbors to let him invest their hard earned funds that I was yelling at the television warning them of impending loss. At least with that show I knew that there would be some form of resolution where the culprit would be arrested, tried in court and face punishment. Yet the hurt, anger and confusion from his victims was raw and real.
As I thought about that episode I wondered….why was it so easy for people to let someone take control over the funds? Money that they saved and that they hoped would give them some security later in life.
The perpetrator in this case was running an investment scam known as a Ponzi scheme. Almost everyone has heard of a Ponzi scheme. In this post I want to cover how they work and why there are usually few funds left to compensate victims for their loss.
A legitimate investment company takes in funds from customers who want them invested in legitimate assets. Their expectation is that there will be a positive return. In other words, the investment will provide some income or will grow in value over time or both. The investment company can charge a fee for their services, take a percentage of the investment’s return or both. Genuine investment companies disclose to investors how they achieve their revenue before any funds are sent. They will not use customer’s funds to pay their own bills. Let’s look at a real example.
BlackRock Inc is one of the world’s largest publicly traded investment management companies. In 2016 BlackRock had an average of 4.8 trillion dollars in Assets Under Management (AUM). These are funds that customers have asked BlackRock to invest for them either directly or indirectly. These funds come from retail customers investing either in BlackRock’s proprietary products or through brokerage accounts where BlackRock handles the trade requests. Institutions also entrust BlackRock to invest 401K funds, pension funds and their own investments in a similar way. These AUM do not appear on BlackRock’s balance sheet as they belong to the individual or institutional investors. BlackRock handles the administration and investment of these funds for a fee. In 2016 the company brought in over $11.1 billion in such fees. This fee income is how BlackRock pays its bills…not by using the AUM owned by their customers.
One way to look at the efficiency of revenue generation for an investment company is their fee income as a percentage of AUM. In the case of BlackRock that comes to 0.228% or less than one dollar of fees for every $438 dollars of AUM (less than ¼ of a penny for each $1 in AUM). The reason for all these numbers is to point out that generating revenue for an investment company depends largely on the amount of funds it invests. Success with investment management is based earning a tiny amount for each dollar invested through the company.
A company engaging in a Ponzi scheme takes funds from an investor and usually promises returns much higher than the customer can find elsewhere. This is Red Flag #1. Instead of actually investing the funds in any real security the fraudster uses the funds for his or her own benefit. In many cases these are used to purchase toys and experiences (mansions, expensive cars, jewelry, airplanes, trips, gambling, escorts and drugs). In order to provide the investment returns promised to the first investors the fraudster has to convince additional investors to hand over funds. Usually the sales person tries to build FOMO in the investor…..the Fear of Missing Out on a “once in a lifetime opportunity”. This rush to invest is Red Flag #2. Some of these funds go to provide the “return” the first investors expect while the rest is used for more toys and experiences.
Any investment company has to provide each investor with a regular statement that shows the amount of their investment as well as earnings, growth and rate of return. A Ponzi scheme is no different. The more official the fraudster can make these statements look the more respectable the investment scheme appears….but creating these fake statements is a lot of work.
At some point the entire shaky project collapses because the fraudster cannot recruit more victims/funds or the police (and suspicious clients) start closing in. When that happens he runs or is arrested. By the time he is arrested it is common to have the media interview victims who often wonder where their investments are and how much they might recover. If this fraudster actually put most of his victim’s funds in assets (toys) there may be some value to return to the victims. But if most of the funds went to experiences (trips, gambling, drugs, cosmetic procedures, gifts and escorts) those funds have disappeared forever.
I have a financial example nearby that helps explain how the funds mysteriously disappear. Look for an animated PowerPoint link where the fraudster promises a 10% return every year and initially recruits 10 victims to give him $1,000,000 each. Ponzi Example – click to advance the slides
In the demonstration I mentioned that the victims would be fortunate to get 25% of their investment back. When homes, cars or jewelry are being sold and the new owners (like law enforcement or bankruptcy trustees) are motivated to sell quickly buyers realize this is a distress sale and will look for a bargain. The buyers will not offer a high or even a market price. It is likely that even the purchase price of these “toys” will not be recovered meaning the victims will recover less than the original cost to the fraudster.
Finally, in some jurisdictions victims who receive a return on their funds must pay that back. The legal reasoning is that the funds came from later victims and was not truly investment income. Talk about adding insult to injury!
Some writers say “if a deal seems too good to be true, it probably is”. I believe that there is no probably to it. If a deal seems too good to be true, it is. As a steward of your own money you must know how risky an investment is. Remember these points:
- If the investment sounds complicated and difficult to understand ask questions until you do understand or discuss it with someone you trust
- Watch for both of the Red Flags listed above, and
- Understand what is possible in any investment environment (more about this in a later post)
If you have received an offer for an investment opportunity that sounds too good to be true review it with your accountant or investment advisor. If you do not have someone like that I would be happy to review it with you and provide my opinion.