What is Investment Fraud?

Video Transcript 

We are all familiar with the type of investment fraud that Bernie Madoff perpetrated with his Ponzi scheme.

A Ponzi scheme involves using funds from new investors to pay returns to earlier investors, creating the appearance of profitability.

The fraud that I am talking about is subtle and insidious.

It’s kind of fraud where investment advisors and stockbrokers convince clients that they are or can beat the market.

This is an investment fraud perpetrated by our largest investment companies and televised daily by companies such as CNBC. This is trillions of dollars invested in fraudulent investment funds and insurance products that consumers purchase their hard-earned money.

It is best illustrated by Warren Buffett’s famous investment "bet" was a challenge he posed in 2007, known as the "Million-Dollar Bet." This bet highlighted his long-standing belief in the superiority of low-cost index funds over actively managed investment funds.

The Bet Details

• Parties: Warren Buffett (via Berkshire Hathaway) vs. Protégé Partners (a hedge fund firm).
• Terms: Buffett bet $1 million that a simple, low-cost S&P 500 index fund would outperform a basket of hedge funds (selected by Protégé Partners) over a 10-year period from 2008 to 2017.
• Investments: Buffett selected the Vanguard S&P 500 Index Fund, while Protégé Partners chose five "funds of funds" (which are collections of hedge funds).

The Outcome

• Results:
• Over the 10-year period, the S&P 500 index fund earned an average annual return of 7.1%.
• The hedge funds returned an average annual gain of 2.2%.
• Winner: Buffett’s index fund won by a significant margin.
• Payout: The prize money (originally $1 million, which had grown to about $2.2 million thanks to investments during the period) was donated to Girls Inc. of Omaha, a nonprofit.

Key Lessons from the Bet

1. Low Costs Matter: The low expense ratio of index funds is a significant advantage over the high fees associated with hedge funds.
2. Efficient Markets: Buffett argues that most active managers cannot consistently outperform the market after fees.
3. Long-Term Investing: The bet underscored the importance of long-term patience and the power of compounding returns.
4. In investing, a novice can outperform a 40-year veteran

Buffett's Takeaway

Buffett has consistently advocated for most investors to put their money in low-cost S&P 500 index funds instead of relying on high-cost active management. He believes this strategy is more effective for achieving solid, long-term returns.

This bet became a cornerstone example of Buffett’s investment philosophy and a powerful argument in favor of passive investing.

The type of fraud we typically deal with.

Unsuitable Investments

• Fraudulent Activity: Recommending investments that are inconsistent with the client's financial goals, risk tolerance, or time horizon.
• Example: Advising clients to invest in high-fee, low-return products that predictably underperform the S&P 500.

Negligence or Breach of Fiduciary Duty

• Fraudulent Activity: Fund managers or advisors fail to act in the best interests of their clients, leading to underperformance.
• Example: Managing a portfolio poorly by not diversifying or by making consistently bad investment decisions.

Index Hugging with Active Fees

• Fraudulent Activity: Selling a fund as actively managed while essentially mirroring an index like the S&P 500 but underperforming due to high fees.
• Example: A "closet index fund" charges active management fees despite offering returns worse than the index it's supposed to outperform.

Affinity Fraud

• Definition: Fraud that targets members of identifiable groups such as religious or ethnic communities.
• Red Flags: Trust built on shared backgrounds; few verifiable details about the investment.

Relies on the concept that investment professionals can create cost-effective, tax-advantaged pairs investments by using techniques such as

Firm Foundation Theory

This is referred to as fundamental analysis, which is based on the premise that financial analysis can reveal a company's intrinsic value.

Castles In The Air theory

This investment philosophy, inspired by John Maynard Keynes, proposes that individual perceptions drive investment. It analyzes past stock prices and trading volumes to predict future changes.

Many investors combine both theories to make stock predictions.

Studies show that over the long term 94% underperform the S&P 500

Many consumers do not realize their investment performance may be suboptimal due to a lack of clear comparisons. They often receive documents that do not benchmark returns, and advisors may not highlight how performance compares to the S&P 500 index fund.

This company offers consumers accurate benchmarks for comparison. It is suggested that all investment advisors and companies should provide this service. Ideally, financial professionals on networks like CNBC would present numbers comparing investments to relevant indexes, though this might not always occur.

Investment techniques that can be compared to low-cost S&P 500 index funds include low beta leveraged funds or risk parity funds. These strategies involve purchasing low beta or low-risk assets and leveraging them.