Question- I have enough confidence in the market to invest, but I worry about fraud...
Question: I have enough confidence in the market to invest, but I worry about fraud. If I buy an ETF, for example, how do I know that the underlying value of the asset is really there — that it’s not some fraud?
Ric:The first thing you need to know is this: investment fraud has existed ever since there have been investments.
The first public investment in this country was initiated by Alexander Hamilton in 1792. As Secretary of the Treasury under President George Washington, Hamilton proposed to have the federal government pay all the debts incurred by the states during the Revolutionary War. State bonds at the time were trading for pennies on the dollar, because there was little confidence that the states could (or would) repay their debts. Hamilton’s plan would reimburse bondholders at 100 cents on the dollar. Word of his plan leaked, creating huge profits by unscrupulous traders.
In other words, that very first IPO was a victim of insider trading. And there has been investment fraud ever since. Likewise, there have been auto accidents ever since there have been automobiles.
The existence of fraud is not a reason to hold back from investing. We just need to acknowledge the risk.
How do you know you’re dealing with ethical people and sound investments? I’ll answer in two ways. First, let’s look at the Bernie Madoff scandal and then at your mutual fund or ETF.
There were several signs that something was amiss with Madoff. For example, investors wrote checks payable to his firm. Investors should never write checks payable to their advisors. Instead make your check payable to the custodian handling your account — firms like Fidelity, TD Ameritrade or Schwab. Our clients, for example, never make their investment checks payable to Edelman Financial Services. They make them payable to TD Ameritrade, an unaffiliated custodian. This way, my firm never has access to or control over our clients’ money. Instead, we are merely advisors regarding securities transactions. None of our clients have to worry that I might leave the country, because I can’t touch their money. That’s an important safeguard for you. You’ll find six more warning signs at RicEdelman.com.
Once you’re dealing with an independent custodian, how can you be sure that the ETF you’re buying is legitimate? You can rely on the system — the New York Stock Exchange, independent auditors, the Securities and Exchange Commission and the Financial Industry Regulatory Authority. This massive amount of thirdparty evaluation goes a long way to assure you that the registered securities you’re choosing, such as mutual funds and exchange-traded funds, are legitimate. (Which does not mean they’ll be profitable, of course! That’s an entirely different question.)
You do have to worry, though, when you’re dealing with a proprietary product that you purchase directly from its manufacturer. For example, if you buy a non-traded REIT, you’re dealing with a company that creates its own fund, raises money from investors and uses that money to buy real estate. With such investments, no third party is involved, other than their auditors. This doesn’t necessarily mean such a company is not legitimate, but you don’t have the same safeguards you have with securities that are publicly traded via the NYSE.
Thus, investors have two concerns, not just one. Most worry about the return on their money. You also need to be concerned about the return of your money.