Five questions to ask before investing
Sometimes we get calls from clients asking us to research certain investments they’ve heard of that promise income without risk. Putting aside the question of whether or not such investments are halal, investors may be unknowingly falling for a potential Ponzi or pyramid scheme. Keep in mind that such a scheme could go undiscovered for decades. Madoff’s Ponzi scheme is believed to have started in the 1970s, but he wasn’t arrested until 2008.
Here are 5 questions you should ask before investing your hard-earned money:
1. Is this a security? If so, is it registered with state or federal regulators?
Under federal law, an investment is a security if it passes the Howey test. Under Howey, an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
An investment is almost certainly a security if its marketing materials (website, brochures, etc.) promise great returns or guaranteed income. Why does it matter? If something falls within the definition of a security under applicable law, it will be governed by extensive rules and regulations that can be complex and expensive to comply with.
For example, a housing co-op we were asked to research recently was soliciting investors to purchase investment shares in their co-op. In return, they promised a halal dividend. However, a brief phone call to their state securities office confirmed that this co-op was selling an unregistered security, which is a serious violation of U.S. securities law. Moreover, selling unregistered securities across state lines violates numerous state securities laws.
2. Where are your disclosure statement(s)?
A registered security will have disclosure statements. These documents will disclose vital information about the investment’s strategy, risks, key officers, potential conflicts of interest, whether there are any legal or regulatory proceedings against the sponsor, its financial standing, and so forth. Such disclosures are filed with regulators so you can be reasonably confident the information you’re reading is official. You need these disclosure statements to help you assess the financial soundness of your investment.
3. What are the risks?
Promises of a guaranteed, no-risk return should be met with skepticism. Investing inherently involves risk. Keep in mind that risk comes in many different forms. Beside the loss of principal, investors may face liquidity risk. For example, investing in real estate poses liquidity risk. The disclosure statements you receive will identify the risks of your investment. Don’t be greedy: ask lots of questions when someone claims an investment has no risk.
4. Where are your audited financial statements?
This question is particularly important for pooled investments that lump all investors together. It’s also critical when the firm will have custody of your money. Before investing, you should request and review the investment’s annual report. This report contains audited financial statements and is accompanied by a letter from its auditors. If the third party public accountant is an unknown entity, do more research. In 2011 we discovered that Madoff’s accountant, David Friehling, never conducted a single audit of Madoff’s books.
5. How can I trust your performance track record?
If someone promises investment returns that are unnaturally high or steady, your warning bells should be sounding. Most managers will eventually deliver average market returns; it’s how you reach those returns that make the difference. So make sure you do your homework on anyone who claims to consistently outperform their benchmark by a very wide margin. This is often the telltale sign of fraud.
Protect yourself by choosing advisers who comply with Global Investment Performance Standards (GIPS). GIPS is a set of voluntary performance reporting standards created and administered by the CFA Institute. Better yet, look for advisers who have their track records verified by a third party.