The list of Bernard Madoff's victims reads like a who's who of prominent business people, banks and financial firms. DreamWorks CEO Jeffrey Katzenberg reportedly invested millions. Banks such as and Austria's Bank Medici could lose billions. An estimated dozens of "funds of funds," which exist to vet and choose the right hedge funds and mutual funds for investors, could lose billions more.
As a former chairman of the Nasdaq stock exchange, Madoff had connections and credentials that kept many investors from seeing -- or taking seriously -- complaints against his companies. Had investors delved deeply into his activities, they would have seen his businesses were not as squeaky-clean as his résumé would suggest.
In June, Madoff received a maximum sentence of 150 years in prison. High-flying financier Allen Stanford is also behind bars, facing charges of fraud and conspiracy and obstruction. He is accused of bilking investors in an $8 billion fraud scheme.
The number of professional money managers duped by people like Madoff and Stanford poses a disturbing question for small investors: How can they possibly ensure their money is in good hands?
If you'd rather not hook up your money manager to a lie detector, there are still ways to protect yourself from bad advice and outright fraud. Here are five red flags to watch for -- some of which could have saved Madoff's investors a big chunk of the $50 billion he's alleged to have vaporized.
The background check doesn't check outThe Securities and Exchange Commission and Financial Industry Regulatory Authority, or FINRA, maintain publicly searchable online databases of all investor charges, disciplinary actions, civil court filings, arbitration awards and bankruptcy proceedings involving brokerages and individual investment advisers. FINRA's BrokerCheck site is particularly helpful. It includes a summary that lets investors easily scan for any suspensions, disciplinary actions or consumer filings -- what the site calls "regulatory events" or "civil events." It also includes detailed reports outlining the specific actions taken.
A search for Madoff's company on BrokerCheck betrayed problems that should have raised some concerns for investors. In August, Madoff's firm paid a $25,000 fine for failing to report accurate trading information. Altogether, the company had five complaints against it -- perhaps not enough to scare off investors but enough to merit questions.
You don't understand the strategyAfter Madoff was charged with fraud, some of his investors admitted they never fully understood his investing strategy. But because they were making money, many believed Madoff was simply smarter than they were.
In an interview with The Wall Street Journal, Burt Ross, a former stockbroker and past owner of a commercial real estate company, explained why he didn't delve deeper into Madoff's strategy. "Who am I to question?" Ross told The Journal. "This guy has a formula involving computerized trading. . . . It's like Coke. We're not supposed to know the formula."
But investors are supposed to know the formula, according to the SEC. The agency recommends that investors ask a litany of questions, including several about how the company makes money. Investors should understand the company's strategy and how it relates to past performance. If the answers don't make sense, don't be afraid to keep asking what may feel like dumb questions.
"We see too many investors who might have avoided trouble and losses if they had asked basic questions from the start," the SEC says in its investor information packet.
Your manager makes a bundle even if you don'tInvestment advisers should be paid by you. Otherwise, don't expect them to work for you. Advisers who earn commissions for selling certain financial products have a strong incentive to direct their recommendations to what makes them money, not what is best for your financial future.
Certain types of mutual funds and variable annuities, for instance, pay your adviser fat commissions even if they're not a good fit for you. Conversely, an investment adviser who makes money from flat fees or, better, by taking a percentage of your portfolio's profits, has a stronger incentive to generate returns for you.