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Investing With The Inner Circle

Last update on: Oct 17 2017
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Investment returns are down, leading many people to seek alternative sources of safe, sure returns. It also brings out the scam artists.

A leading scam these days (#5 in the top 10 of the North American Securities Administrators Association) is known as the “prime bank” scheme. The scam is perfectly designed to attract the average person who needs higher returns and perceives that the wealthy and elite institutions consistently earn higher returns than he is.

Here’s how the scam works. An investment manager says that the world’s “prime banks” and wealthy individuals are able, because of their status, to earn high returns. The money manager says that regular people can participate in these investment strategies. They have to turn their money over to an investment manager who is “plugged into” the inner circle. This money manager happens to be plugged in to the insiders.

The returns available from these strategies vary, but always are far above what any public investment earns. Often, triple digit annual returns are quoted, but some schemes promise returns up to 70% per week. To emphasize the safety of the investment, the investment manager shows a written guarantee of the promised returns from one of the prime banks, which might be described as a top 25 European bank or top 100 global bank. The bank always is a non-U.S. bank. The guarantee isn’t real. Either it is forged or the bank doesn’t really exist.

Unfortunately, none of the statements about the investment are true. Investors receive regular statements purporting to show how well their investments are doing. The investment manager, however, spends most of the money, and some money periodically is paid to investors as income distributions to convince them that the returns are real.

There are no special, secret investment strategies for the inner circle of select investors. I am a trustee of two major public pension funds. If there were such strategies, I think I would have heard about them. There are, however, a few investment vehicles around that can provide high returns and are available only to wealthy individuals and to and institutional investors. The existence of these vehicles helps the scam artists establish some credibility.

Hedge funds are lightly regulated investment partnerships not available to the general public because of regulations. Some hedge funds use strategies not generally used by mutual funds – such as shorting stocks – and also use a lot of debt to increase their returns. It is not unusual to see hedge fund returns of 50%, 100% or more in a year.

Hedge fund returns, however, are not guaranteed. The debt creates a lot of risk. It is not unusual for a hedge to earn 100% one year and lose 20%, 30%, or more the following. Many hedge funds “blow up.” Their risky investments do poorly and lose all or most of their investors’ money, so the funds liquidate and fold. The wealthy and institutional investors who purchase hedge funds are advised to buy a diversified portfolio of funds so that good years by one set of funds will offset bad years by other funds. It is a high risk investment with potentially high returns.

Private equity funds are similar. They aren’t open to the general public and can earn enormous returns. These funds invest in non-pubic companies. They might fund start-up companies, growing but non-public companies, or take public companies private – among many other possible strategies. Many private equity funds did extremely well in the years before 2000. More recently, most of these funds have seen their portfolios decline by 50% and more. Those who invested late in the game have lost almost all their investments.

The difficulty for private equity funds these days is that they have no way of cashing out their investments. Private equity returns depend on a healthy stock market so that the privately owned firms can be taken public. With the market for new issues almost non-existent the last few years, private equity investors must wait to get cash from their investments.

Investment banks have their own trading divisions. These divisions take the firms’ own money, borrow some additional money, and invest. They often use strategies similar to those used by hedge funds. In fact, most hedge fund managers were trained in the trading divisions of the investment banks. Again, the investment returns are not guaranteed. If you read the financial reports of investment banks, you’ll see that a bank might earn hundreds of millions of dollars from its trading division in any year. The same bank also might lose quite a bit of money in its trading division another year.

There are investments that are not available to the general public, largely because of federal regulations. Yet, these investments do not have guaranteed returns and there is no inner circle of elite investors guiding each other to the same investments. It also is very difficult to track the positions of the most successful of these investments. The investors go to great lengths to hide their positions.

The myth of the inner circle of investing is so powerful that many of the wealthy themselves often get scammed by such deals. They believe that unique returns are available to them. They also assume that the other wealthy investors in the deals thoroughly investigated it, so there is no reason for them to duplicate that work.

If you’ve been following my investment recommendations the last few years, you’ve done better than many insiders. The “secret” to successful investing is to limit your risk by investing with a margin of safety and maintaining a balanced, diversified portfolio.

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