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Dear Valued Client,
At some point, years from now, 2008 will likely show up on a chart of market performance as a small downward jog in a generally upward sloping line. Anyone looking at the chart that hadn't lived through this year would likely skip over it, blissfully unaware of all the drama that has unfolded. For those of us that are invested in the here and now, the good news is that volatility appears to be waning a bit and markets are well off their lows. Whether or not this will continue to be the case is something we'll discuss in the year-end commentary in a few weeks.
For this month's newsletter, we take a look at the fraud perpetrated by Bernie Madoff, and examine the protections our clients have against such a fraud. Next, we discuss how state regulators can assist you in resolving issues with health insurance providers. In the final column, our client question of the month covers our thoughts and concerns about the auto bailout.
Our call-in for friends and family last month was a success, so we're going to repeat it in January. We've set aside 9 am to 1 pm on Friday, January 16th as a time for them to call us at 877 881 5379, so please feel free to pass this information along to them.
Lastly, as the year draws to a close, we'd like to offer our thanks for your support. We wish you and your family Happy Holidays and a Happy 2009.
Sincerely,
Micah Porter, CFA
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Protection against fraud - The case of Bernie Madoff
Micah Porter, CFA
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Of all the financial stories of 2008 - and this certainly hasn't been a lean year for those - one of the most fascinating is that of Bernie Madoff. His story is still being unravelled, but the early details seem to indicate that he perpetrated one of the largest frauds in history, defrauding everyone from the richest and most powerful to middle-class retirees of somewhere on the order of fifty billion dollars. So how did he do it, and how does one avoid such a scam?
For the last several years, Madoff apparently managed his investments as a series of separate accounts. What that means is that every investor who worked with him had their own account, and Madoff managed all of those accounts according to his supposed strategy. He was registered with the SEC, which meant he was theoretically subject to regulation, and he also sent statements to his clients on a regular basis. So what should have raised a red flag with potential investors?
Madoff acted as his own custodian. Madoff not only managed client assets, but one of his firms actually had custody of the assets as well. This allowed him to falsify brokerage statements sent to clients to cover up the huge losses that the clients were incurring.
It is generally a good idea to ensure that if someone is managing your investments, those investments be custodied with an unrelated third party, and furthermore that you get statements from the custodian as well as the advisor on a regular basis. Madoff never would have been able to defraud his investors had there been an independent custodian holding his clients' assets.
Madoff's returns were too good to be true. Trying to consistently beat the market is extremely challenging, and few do it successfully. Trying to beat the market while maintaining consistently positive returns is an order of magnitude more difficult, yet that is what Madoff told his clients he was able to do. Several of those potential clients did a bit more investigation, and quickly decided not to invest with him.
Many of Madoff's clients had no idea he was actually investing their money. Many of Madoff's investors came to him via third parties who invested client funds with him. The third parties weren't always clear about the relationship, and in some cases investors only found out they had funds invested with Madoff when news of the fraud surfaced and they found that the investments were worthless.
What makes this particularly galling is that many of these third parties were managers of funds of funds, whose sole responsibility is seeking out hedge funds in which their clients can invest. Such funds typically charge a minimum of 1% plus performance fees, and these fees are on top of the fees charged by the individual hedge funds - typically well in excess of 2% for funds that perform well. The firms justify these fees by pointing to the access they provide to top funds as well as the amount of due diligence they carry out.
Here is a snapshot of the web page of a firm, Fairfield Greenwich, that had $7.5 billion in client assets invested with Madoff. The page describes the initial due diligence process, which was clearly, at least in the case of Madoff, not followed. In exchange for simply funneling investments to him - which represented a bit over half of Fairfield Greenwich assets - the firm likely made $100 million per year, according to Henry Blodgett at Clusterstock.
While Madoff wasn't technically running a hedge fund, the lack of transparency and the high fees are common among hedge funds, and they are both reasons we've chosen to this point not to invest in this sector. Further, we would never invest with a manager that also acted as custodian - the opportunity for fraud is just too great. Lastly, if we can't at least gain a basic understanding of how a manager is achieving their returns, we think investing is just too risky. Given the above simple principles, should many of the supposedly smart, wealthy investors have been able to avoid this scam? Sure, but in the instance of those that knowingly invested with him, greed for such attractive returns overrode their common sense.
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Financial Planning Tips - Insurance Companies and State Commissions
Micah Porter, CFA
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In last month's newsletter, we took a look at how state regulators might assist you in the event you run into issues with a utility company that you can't resolve on your own. This month, we'll take a look at another regulated industry, insurance, and we'll focus specifically on health insurance as we've had more experience in this particular area.
Most states have an organization that is specifically tasked with regulation and oversight of the insurance industry, and in Georgia, the organization is the Office of Insurance. The Commissioner is an elected official and the office can assist with problems on all types of insurance, including auto, home, life, health and business insurance. As was the case with assistance on utility issues, you should first try to resolve the issues with your insurance company before turning to the state regulators.
I want to focus on health insurance, as in my experience that is where conflicts between consumer and carrier arise most frequently. For folks that are on group plans, quite often the best advocate is your employer or the organization providing insurance to its retirees. In these instances, you've got the weight of the organization behind you, and HR or others within the organization may be able to assist you in resolving the issue with your healthcare providers. However, for those of us who insure ourselves, filing a complaint with the regulator can often help resolve intractable problems.
I found this out myself several years ago when a friend who lived in Florida ran into issues with his carrier. My friend had an individual policy and had recently undergone some minor surgery. He followed the process to the letter in terms of getting the appropriate medical referrals, but when he submitted his claim, the insurance company denied it claiming insufficient documentation. When he investigated further, he found that the insurance company wanted the referring physician's original records, not copies, and without that they would not pay the claim. When my friend checked in with the physician, who had been his family's doctor for decades, the physician balked, explaining he never released his original records.
Caught between a rock and a hard place, I suggested my friend contact Florida's insurance commissioner and let the insurer know he was going to do so. Once he did this, the insurer found that apparently the documentation they had been provided was sufficient, and they processed his claim within 24 hours.
Hopefully, you'll never find yourself in a situation in which you just can't reach a resolution with your insurer. If you do, however, don't overlook the idea of turning to a state regulator to see if they can help and don't hesitate to discuss the issue with us as well.
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Client Question of the Month
Micah Porter, CFA
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While this isn't a specific question, a number of clients have asked what I thought about the auto bailout. Firstly, whether or not all should be saved is an open question, but looking at the combined sales of GM, Ford and Chrysler, it's clear that they *are* making at the very least some products consumers want. However, it's equally clear that given the persistent issues that the automakers have had in running their businesses profitably, some sort of serious restructuring is needed and perhaps all three shouldn't survive.
In a normal market, the restructuring could likely be achieved through a pre-packaged bankruptcy. However, the problem is that this isn't a normal market, and the automakers would likely have trouble securing financing to tide them through bankruptcy. Thus, instead of bankruptcy resulting in reorganization, in the absence of financing it would lead to liquidation.
Given that there seems to be a fairly broad consensus that a stimulus package is needed for job creation, liquidating the automakers at this particular time wouldn't seem to be a great idea. Having said that, if the government provides loans without forcing the necessary restructuring - and that is a real possibility - then a bailout would ultimately be a waste of taxpayer money. Here's hoping that isn't what is going to happen.
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