How to Smell a Rat: The Five Signs of Financial Fraud
Summary
Ken Fisher wrote this with Lara Hoffmans immediately after the Madoff arrest, and the argument is narrow and practical. Fisher claims that nearly all investment frauds against retail clients share five detectable features, and that an investor who checks for them can avoid the great majority of losses without any ability to analyse the underlying strategy.
The first and most important sign is that the adviser has custody of client assets rather than using an independent third-party custodian. Fisher treats this as close to decisive: if the money sits at a large unaffiliated custodian that sends statements directly, the adviser cannot fabricate returns. The remaining four are returns that are consistently positive and smooth, a strategy the adviser will not or cannot explain, marketing that emphasises exclusivity or shared membership of a religious or ethnic community, and delegation of due diligence to a third party such as a feeder fund or consultant.
The book is short and repetitive, and Fisher's own firm benefits commercially from the advice, since it uses third-party custody. He also does not address frauds inside institutions with legitimate custody arrangements, such as accounting fraud at operating companies, or the sales-practice abuses that cost investors more in aggregate than outright theft. Within its scope the custody point is correct and remains the single most useful thing a retail investor can check.
Key takeaways 7
- Independent third-party custody of assets eliminates the mechanism by which nearly all retail investment frauds operate.
- Consistently smooth positive returns indicate fabricated or smoothed marks rather than skill, because real strategies produce variable results.
- An adviser who cannot explain the strategy in terms the client understands should be treated as concealing something.
- Affinity marketing through religious, ethnic or club networks substitutes social trust for verification and is a recurring feature of frauds.
- Investors who delegate due diligence to a consultant or feeder fund have not performed due diligence.
- Regulatory registration and long track records provide no protection, since Madoff had both.
- Fisher argues that these checks require no financial expertise and take less than an hour, which is why failing to perform them is inexcusable.
Who should read it
Individual investors and family offices selecting outside managers who want a short verification checklist rather than an analysis of fraud psychology.
About Ken Fisher
Founder and Executive Chairman, Fisher Investments; Forbes "Portfolio Strategy" columnist 1984-2016
A long, public money-management record plus Super Stocks, which introduced the price-to-sales ratio and outlived its news cycle.
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