Dropping in to speak to Cayman’s investment professionals during a whirlwind tour of the Caribbean and South Eastern US, Philip Lawton of the CFA Institute and Head of the CIPM Programme gave an interesting presentation on the importance of protecting investors in good times. Business Editor Lindsey Turnbull was in attendance and reports in this two part series.
Swindlers, according to Philip Lawton, flourish in a bull market but only come to light when investments head south, thus it is particularly important to protect investors when times are good.
Lawton, speaking to a packed audience of Cayman Islands Society of Professional Accountants and CFA Society of Cayman members at The Wharf at the end of August, targeted his speech specifically at those investment professionals who were responsible for engaging investment fund managers and monitoring their progress and who were thus in a position to protect investors from the swindlers and the fraudsters.
Analysing performance of these managers in a comprehensive way was, according to Lawton, the key method of ensuring that they were not trying to defraud the investor.
Lawton’s discussion was particularly timely in light of the fact that, when the tide of bull market profits ebbed in 2008, it exposed many fraudulent investment schemes but only after it was too late for investors to recover full value. Now that the tide is expected to rise again, Lawton was able to explain to the audience the intricacies of manager selection as well as monitoring techniques designed to uncover misrepresentation.
Lawton is head of the CFA’s CIPM programme (Certificate in Investment Performance Measurement), a year-long certification programme open to anyone (not just those who are CFA qualified) which focuses on teaching investment advisers and other financial services professionals performance measurement attribution and appraisal, how to calculate returns and judge whether they are achieved through skill or luck and how to judge by the GIPS (global investment performance standards).
How to spot a swindler
Lawton said that there were various stages of analysis where an investment professional ought to be able to spot when something was just not right. Firstly they should be contemplating the portfolio return and then understand the sources that created that return. They should be able to judge whether those returns were due to skill or luck, or possibly fraud.
“Performance evaluation techniques are not designed to detect fraud, as we are not private detectives, never-the-less they may raise timely questions that need to be asked,” he clarified. “This may then lead to a process of discovery with a manager.”
Lawton then analysed two bull markets in recent history – from mid 1994 to 2000 (“a rich period for many, which ended abruptly in March 2000 when many learned what risk really was,” he said) and then again from 2003 to 2007.
During boom times such as these undiscovered embezzlement (“the bezzle” according to John Kenneth Galbraith who wrote about the great stock market crash of 1929) increases.
Googling the words “the SEC charges…” Lawton said that the phrase (which indicated the frequency for which the US Securities and Exchange Commission charged an investment advisor with fraud or similar) occurred 76 times in the twelve month period leading up to the end of 2005. In the twelve months leading up to the end of June 2009 that phrase occurred 215 times, i.e. a 180 per cent increase in the number of SEC cases noted. Likewise Lawton looked at the occurrence of the Federal Bureau of Investigation’s Ponzi schemes that were under investigation. Three years ago the FBI was looking into 300 such schemes. That figure was now around 500. Thus indicating that when times are bad, such as now, fraudulent schemes come to light.
Headlining swindlers and fraudsters in recent times included Enron, Worldcom and HealthSouth from the period 1994 to 2002, with Madoff, Stanford and Donnelly making the headlines recently (though Donnolly was, according to Lawton, just small fry compared to the other two, having swindled investors out of US$50 million in his home state of Virginia.)
When things are too good to be true
Manager selection was a crucial stage in the client protection process, according to Lawton. He said that historical returns needed to be analysed and assessed against benchmarks such as the performance of the S&P 500 and the LIBOR (London Interbank Offered Rate).
Lawton showed an example of a seemingly outstanding manager whose returns were constant throughout the lows and highs of a set period. Using this example of an uncommonly skilled manager, Lawton highlighted their constantly positive returns over an extended period which were consistently above the LIBOR benchmark with no negative numbers at all. This manager escaped the hypothesis testing by consistently achieving results above the upper edge of confidence intervals.
“There is a fine line between being too good to be true and being simply very good at what you do,” Lawton said.
In this case the investment manager turned out to be too good to be true and was in fact one-time financier Bernard Madoff, who was convicted of defrauding investors out of around US$65 billion in one of the biggest frauds of all time.
“There is no such thing as gracefully winding down a Ponzi scheme,” Lawton stated. “The only way is disgrace!”
Read more about how to protect clients when times are good next month.