Lessons from the dark side: Check out your advisor

Let's face it - the investment world seems to attract more than its fair share of Joe Isuzu's. I cringe every time I read about another fraud or misrepresentation. Bernie Madoff wasn't the first and he won't be the last. You need to learn to protect yourself.

In my desk I keep a file labeled "The Dark Side" containing news clippings and stories about slimy financial advisors and how they rip off clients. I use the stories to help teach people about the dangers of unscrupulous advisors and the things investors can do to protect themselves. Some of the cases are relatively innocuous; some are egregious. But no matter the scope, in most cases the victims could have prevented the harm they experienced by following some relatively simple steps to check out their advisor.

For example, here on the Monterey Peninsula scamster William Jay Zubick was convicted in August 2007 and sentenced to 24 years in prison after bilking friends and neighbors out of more than $13.5 million. Zubick claimed to have a trading strategy that would generate 10 to 12 percent annual returns. Zubick's "clients" were delighted when he reported returns of 18 to 24 percent returns. Unfortunately, the reported returns were fakes.

Zubick was not investing the money. He was spending it on a lavish life-style that included homes, cars, and travel. It was classic fraud built on misplaced trust and ignorance. Tragically, the fraud could have been avoided if the victims had done a little research. In the case of Zubick, a little research would have revealed that in 2000 he was barred for life from the brokerage industry because of serious regulatory violations. (If you want to read the notice of the enforcement action, click here and then search on the name "zubick.")

In response to situations like the Zubick fraud, financial regulators have put together more user-friendly websites to help investors research their financial advisors. The type of advisor you are researching will determine which regulator is responsible and which website you should use.

Brokers. A broker, or anyone earning a commission as a representative of a securities firm, is registered with the Financial Industry Regulatory Authority (FINRA). FINRA was created in July 2007 from the NASD and the regulatory arms of the major stock exchanges.

Registered Investment Advisors (RIA's). RIA's are advisors who receive a fee for providing investment advice. They are registered with the U.S. Securities & Exchange Commission (SEC).

The applicable websites for each group are:

FINRA - www.finra.org

This website will allow you to check out the background of a broker or search to see if your broker or brokerage firm has faced any disciplinary action. (Click here and then type in the name in the search box in the top right corner.)

SEC - www.sec.gov

This website allows you to find the public disclosure document (form ADV) for a Registered Investment Advisor. This document will tell you about the firm and its owners including any disciplinary action or penalties they may have in their past.

Other Questions to Ask

There are other ways to check out your advisor. Here are some ideas

  1. Ask the advisor for professional references. I am not a big fan of client references for the purpose of checking out an advisor. They can easily be manipulated and you will only receive a list of satisfied clients. Instead, ask for professional references (CPA's, attorneys, etc.) with whom the advisors has dealings. Professionals should be able to give you a better sense of the advisor's qualifications and trust-worthiness. Ask them questions like:
    • How many clients do you have in common with the advisor

    • How long have you worked with the advisor?

    • Do you have any kind of revenue sharing arrangement with the advisor?

    • What kinds of situations have the seen the advisor handle well?

2. Ask the advisor to explain her philosophy about investing and the markets. Pay attention to how the advisor answers. Ask yourself:

  • Does the advisor make sense?

  • Can I understand what the advisor is doing?

  • Does it sound like a "get rich quick" appoach?

  • Is it based on proven principles?

3. Ask the advisor for performance numbers relative to an appropriate benchmark. You may be tempted to do this to see if the advisor has "beat the market," but try to resist that temptation.  The point of this question is to see if the return numbers are consistent with market returns. A fraud will almost always try to lure you in by showing strong relative performance. Bernie Madoff's victims were always astounded by his seeming ability to defy gravity. No matter how badly the equity market performed, their portfolios generated solid returns. Don't allow yourself to be fooled by that kind of malarky. A portfolio of stocks will track the stock market. A portfolio of bonds will track the bond market. And the same holds true for every other asset class. You can't combine them and get something that is totally unrelated to all of them.


4. Ask the advisor about the "custodian" of the accounts under her management. The custodian is the entity that actually holds the assets. In our firm, for example, the custodian for most of our clients is Charles Schwab. Each client has his or her own Schwab account and Schwab sends each client a monthly statement independent of our quarterly reports to the client.  The Schwab statements show account balances, holdings, and transactions.  The independent reporting means our clients always have an independent confirmation that what we are reporting is accurate. If your advisor does not use a separate, independent custodian, insist upon it. If the advisor will not comply, get a new advisor. Zubick would never have been able to defraud his victims if they had insisted upon an independent custodian.

 The financial world can be dangerous. A good advisor can be an invaluable ally. But do yourself a favor - check out your advisor carefully before giving them access to your wealth. Your peace of mind and the safe keeping of your hard-earned wealth are worth a little extra time and effort.