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Doing the Diligence

Date: Wednesday, November 25, 2009
Author: Steve Dalton, Financial-Planning.com

It has becoming glaringly clear, in the wake of Ponzi schemes (Bernard Madoff, Arthur Nadel, Nicholas Cosmos, Alan Stanford), hedge-fund insider trading scandals (Raj Rajaratnam at Galleon Partners being the latest as of press time) and the severe volatility in the equity, credit and real estate markets, that people of wealth need an additional set of eyes. Those eyes belong to you, the wealth manager, who must watch for appropriate opportunities and, more important, identify potential sources of risk to clients' investment portfolios, unfettered by conflicts. Independent investment consultants are ideally positioned to supply this service.


Bernard Madoff's $65-billion scheme was sophisticated, simple and yet fundamentally different than a typical Ponzi scheme, according to some industry experts. Briefly, Bernie Madoff coupled the lure of a fund generating stable high single-digit returns with the scarcity value of joining an exclusive 'stay rich with no risk' club to attract wealthy investors. These investors were willing to forgo almost any due diligence.

The recent rash of Ponzi schemes is no accident. Cheap debt and a diminishing-return investment environment coupled with greed and oversight failures were the perfect breeding ground for such activity.

Fraud is always hard to uncover, but the fact that no U.S. banks had exposure to Madoff's scheme indicates some awareness that something was wrong. Indeed, Madoff found his investors not through traditional routes, like U.S. banks or creating and running a mutual fund—where due diligence was more likely to be performed-but rather from individuals and board members of foundations. He also used feeder funds and foreign banks, which reduced transparency to the ultimate investor. The individuals and institutions taken in by the scam surely would have benefited from a second set of eyes—to make sure due diligence was performed on their behalf. A few relatively straightforward questions would have uncovered enough red flags to slow and perhaps stop the rush to 'get in with Madoff.'


First, asking about broker-dealer relationships would have uncovered the fact that Madoff controlled the sole broker-dealer servicing the fund. Along with the custodian and the accountant, the broker-dealer is at the center of the checks and balances on the valuation of assets within a fund, and independence from the fund manager is essential.

Second would be questions about the accountant. Learning that one of the best-known investment professionals on Wall Street had engaged an obscure accountant in upstate New York should have been a flashing red light. Third, the failure of SEC to identify and halt this scheme early on points up the fact that you can't rely on the government when protecting investments—yet another reason why every client needs a second set of eyes.

Fourth, a manager's unwillingness to answer questions or provide documentation beyond client statements, particularly when linked with a threat to lose access to the fund, should have caused investors to walk. Madoff's apparent refusal to discuss how the fund worked should have been enough to produce a strong recommendation to invest elsewhere.

It goes without saying that the feeder funds, if not outright co-conspirators, were at least compromised by greed (high referral fees from Madoff and, in some cases, participation in Madoff's fees). However, their clients were left exposed by the lack of a second set of eyes, emotionally detached but committed only to their interests, to ask these and other questions, in order to prevent their exploitation and loss of capital. Independent investment consultants provide this service without bias or conflicts. Such counsel can be seen not only as an insurance policy of sorts, but as a partner to assist in realizing investment goals.


Even wealth managers can benefit from collaborating with an investment consultant to identify and review clients' investment goals, create and/or revisit investment strategy and asset allocation and conduct manager searches. It is at the latter step that the all-important due diligence is performed. Additionally, ongoing monitoring of selected managers, including customized performance reporting as well as periodic business, ownership and regulatory reviews are a critical part of the services such consultants provide. Finally, a consultant can vet and generate new ideas to keep client portfolios fresh and current with both client priorities and market conditions.

Independent investment consultants can work seamlessly with a family office, wealth manager or other investment professional as a part of a team. The consultant is most effective as an objective chief investment officer for hire, at a flat or hourly fee, assisting you in managing your investment managers. This can lead to better execution and results. First, communication is usually improved within and among all those involved with your clients' investments. Second, a trusted and unbiased expert working in collaboration with you and other advisors (attorney, accountant, and family office manager) on investments can take the lead or follow on projects.


There are a number of professional advisors who may appear to be capable of providing this service. However, each in turn has some drawback which prevents it from being best suited to the task. Investment managers typically are strong in their specific realm of investment expertise, i.e. high yield bonds or small cap value stocks. Their interests are centered in their product offerings, not in the particular objectives of their clients beyond those products' performance. Client service beyond performance reporting is many times not a priority. Wealth managers usually have a broader investment scope, but again often are wedded to a list or stable of managers, despite pledges to open architectures and platforms. Financial planners, though generally relationship-centered amd aligned with their clients' interests, have varying levels of investment expertise.

Independent investment consultants, however, are singularly qualified to deliver this service. They integrate objectivity, deep and broad investment expertise through tailored communication to the sole benefit of clients. A dynamic relationship anchored in trust and collaboration is a natural result. Charlotte Beyer, founder and CEO of the Institute for Private Investors, has said that "investors today want to be more involved as a partner with their financial advisors and managers." She avers that "investors don't want to abdicate responsibility for their own wealth management."

A solid investment professional with nothing to hide should welcome a second set of eyes. The addition of the investment consultant generates additional flexibility for the rest of your team and leads to better manager responsiveness, deeper understanding of the sources of performance, as well as maintaining appropriate risk and reward expectations. Often peace of mind is a natural outcome. Institutional investors have benefited from this type of counsel and assistance for decades. Now, people of wealth can avail themselves of the same kind of support. It's no accident that most of the victims of Bernie Madoff's investment fraud relied solely on investment managers, without counsel or guidance of any kind.


Steve Dalton is the founder of RSV Consulting Group, an investment consulting firm providing collaborative and objective guidance to wealthy and ultra-high net worth individuals and family offices.