Blind investing – a prophylactic

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Most of us work hard and diligently earning our money but weirdly less so when there’s a surplus and we invest it, too often exposing ourselves to fraud or shaky schemes. Here Shinya Deguchi, an investment professional and founder of Star Magnolia Capital, shares some Investment Fraud Protection 101. You’d be amazed how simple, (not necessarily easy), the measures are. Take strong, straight-line returns; they’re an outlier in the hurly burly, volatile marketplace. There’s good reason for this. While you may get lucky with one in 10, the bulk often end in tears. Deguchi says by all means trust – but always verify. He lists some cautionary steps which may well be your most rewarding workout ever. And speaking of trust, form alliances, check out and share fund track records and experiences. None so blind as these who won’t see – or who operate in isolation. – Chris Bateman

The Importance of Being Diligent

It is not volatility that is the biggest risk to investors; it’s losing capital as a result of fraud.

By Sharon Wood

Shinya Deguchi, founder of Shanghai-based multi-family office, Star Magnolia Capital, has been an investment professional for almost two decades; a job he is so passionate about that he sees himself doing it for the rest of his life. In his spare time, he has another passion: to help fellow investors identify and avoid investing in fraudulent investment schemes.

Sharon Wood

Investors have lost tens of billions of dollars in financial fraud over the years. Bernie Madoff alone defrauded his investors of up to $65bn. In Shinya’s early days in the investment industry, he, too, was the victim of fraud when his first employer, Melco Holdings, invested in a US hedge fund and it turned out to be a fraudulent investment scheme.

Shinya’s brush with white-collar crime set him on an earnest mission, investigating financial fraud and sharing his insight on how it can be avoided in future. He publishes these fascinating case studies on his blog, The Importance of Being Diligent.

In an interview with AssetOwner, Shinya shares his findings after many years of doing this research. Primarily, he has found that even sophisticated frauds have red flags because it is difficult, if not impossible, to design a perfect crime. If you dig deep enough, you can identify these. But first, you need to overcome your human frailties. Shinya says that in his experience, it doesn’t matter how smart investors are, human weaknesses exist. He recently found this out close to home when his friends were caught up in the TCA Global fraud even though he had expressed various concerns about the fund, including its unusually stable – and steep increase – in returns.

They continued to ignore his concerns when he found the auditor had qualified the financial statements of TCA because of concerns about the quality of the assets. As a result, the company was required to halve the previously stated return numbers – to 6–7% from 15–20% – but failed to do so in its marketing. In October this year, the SEC charged the principals with fraud.

So, how can investors avoid falling prey to financial fraud? Shinya explains: if you are a sensible business manager, you put checks and balances in place and it’s the same with investing, where preparedness is essential. His mantra is: ‘Trust but verify’. To help you do so, he has come up with the following framework to verify you are doing good business with good people. This aspiration drives all his professional endeavours.

  1. Straight-line performance is rare – be sceptical of it

Investors make the mistake of seeing volatility as a risk when the real risk is losing capital. Financial fraudsters take advantage of investors who are taken in by their strong, straight-line returns. However, it is almost impossible to run an investment fund for years without having some volatility in returns or, over 10 years, a substantial draw-down. All investors should know this simple fact and avoid investing in any investment scheme that reports straight-line performance.

  1. Don’t rely on regulators to identify and prevent white-collar crime

Regulations are important safeguards but they aren’t perfect. White-collar criminals are experts at finding loopholes in regulations and taking advantage of these. Then, when these are closed, they move on to find other opportunities in other market areas. For instance, loosely regulated hedge funds were fertile ground for fraudulent activities. But with the industry now subject to more regulatory oversight, white-collar criminals have moved on to the crypto space. With this in mind, you cannot rely on the regulators to protect you; it is crucial to do the legwork yourselves.

  1. Conduct your own in-depth due diligence

Asset owners who conduct rigorous operational due diligence rule out most fraud cases. To do sufficiently rigorous due diligence, you need to:

  • Read all legal documents, including the private placement memorandum and limited partnership agreement.
  • Verify the asset under management by speaking to the valuation agents.
  • Understand where the performance is coming from.
  • Confirm the standing of the auditor, administrator and legal counsel.
  • Check for red flags, including an unexplained change in the auditor or a qualified audit, by speaking to previous and existing auditors.
  • Review audited financial statements.
  • Conduct background checks on all the key personnel at the firm.
  • Do on-site visits and interview members of the firm.
  1. Create a circle of trust

Speak to other investors and share experiences and insight about investment schemes you’ve come across. Most investors do not have inside information, so it’s challenging to uncover a fraud unless you do deep, time-consuming research on your own. With many minds on the job, however, the red flags will be easier to spot. Hearing other, independent viewpoints will also help you move past your blind spots. When an investment proposition looks compelling, it is ultimately too good to be true.

For investment peers interested in learning more about protecting themselves from fraudulent schemes, Shinya runs the knowledge-sharing room: ‘Let’s exchange our experiences of fraudulent investment schemes’ on AssetOwner, a privacy-first social platform for sophisticated investors.

At the end of December, he will be starting a series of hedge fund video discussions about fraudulent activities that he has studied, the latest of which is Singapore-based Envy Asset Management’s S$1.2bn nickel trading scam.

Those interested may join his room on AssetOwner.

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