Five Due Diligence Must-Dos

Ascot Partners. Sound familiar? No? You’re not alone. Let’s try again. Familiar with Bernard Madoff? I’m betting you are. Yet the two are part of the same story. Ascot Partners was one of the funds that fed into Bernie’s hedge fund (feeder funds). The folks who did due diligence on behalf of Madoff’s eventual victims. And, depending on who you believe, they were either co-conspirators or flat-out didn’t do their job.

I think many shared my hope that a silver lining to the Madoff cloud would’ve been investors’ placing heightened importance on doing detailed due diligence on potential advisers. Sadly, the facts show otherwise. According to Ponzitracker.com, at least 67 Ponzi schemes were uncovered in 2013, the largest being Edward Fujinaga's estimated $800 million scam. Proper due diligence helps protect you from the crooks. But it can also help you identify honest, capable advisers.

Not surprisingly, Wall Street and the financial press do little to help investors in this regard—often sharing a flawed approach. Now, due diligence is personal—everyone has his or her own approach to getting comfortable with an adviser. Far be it from me to suggest all you need do are follow my simple instructions. (Which could be seen as me steering you to MarketMinder’s parent company and my employer, Fisher Investments.) Rather, I aim to share five foundational factors for due diligence so important I believe you’d be remiss not to include them, whomever you decide to hire for financial advice.

1. Understand—in full—how your potential adviser is paid.

This is a must. Ask for an explanation in writing! In my experience, few investors can correctly explain the total costs incurred through working with their adviser. Knowing exactly how much you pay—and for what—is one of the simplest ways to thin the herd of potential suitors seeking your business. Payment is their incentive, and incentives matter to behavior. For example, if you have someone paid to trade, will they tell you not to? Do they counsel you and explain how their advice is tailored to your goals with your best interests in mind, or do they knuckle under to your viewpoint and become your personal “Yes Man?” If it’s a pay-for-performance structure, how has the adviser planned to hedge against the desire to swing for the fences? If your adviser will earn fees, are they fee-only or fee-based? Believe it or not, those are two different things (“Fee-only” means the adviser earns no commissions at all. “Fee-based” advisers may earn commissions, too.)

Here again, it’s not my place to render judgment on the merits of commission vs. fee-only advice. But whatever method they employ, you owe it to yourself to clearly understand the structure and think about the behavior it encourages. If the potential adviser cannot directly explain how they are paid from all sources, or if they provide a poorly written, hard-to-understand bunch of gobbledygook, what does that potentially say about his or her values? Are they trying to be confusing or just failing to communicate?

2. Verify the adviser’s experience and history.

When you select an adviser, you make a hiring decision. Shouldn’t you see their resume? Understand what they’ve done and when?

Familiarize yourself with the adviser’s professional history and ask for a written, third-party-verified history of returns or recommendations. This won’t always be available. Brokers (often called Financial Advisors) recommend different products or securities to different people. (Even if they offer a product to everyone, not all clients buy in.) What this means to you is there is no performance history the Financial Advisor can show you. None. A red flag here is the adviser who lacks a written history claiming you’ve done poorly when all they can show are hypothetical returns of a portfolio they can’t prove to have recommended to anyone. This is common practice on Wall Street, and it’s bunk. Anyone can construct a portfolio of what did well over the last five, seven or ten years. But it’s not relevant to you now. Another red flag: An adviser who pumps performance only. This is a red herring as well, because you can’t buy past returns. Advisers pushing these “factors” are showing you something about their values. They are selling to your inner greed.

3. Conduct a basic background check.

Visit the Financial Industry Regulatory Authority’s (FINRA) or Securities and Exchange Commission’s websites to complete a Broker Check and Investment Adviser Search, respectively. These public and free resources share a good deal about the financial professional, including their industry experience, securities licensing, outside business activities and any regulatory event—all relevant information for the investor. If you are hiring a Registered Investment Adviser, you might also reference the ADV II—a comprehensive series of disclosures of conflicts of interest and facts about the business. This is a treasure trove for the would-be client.

Note: Licensing is important to get into this industry, but you shouldn’t think of it as conveying expertise. What it says more about is what the adviser is permitted to do. For example, don’t expect a Series 6 registered agent to explain the structural issues with annuities and mutual funds. That’s what they are licensed to sell.

4. Ask about errors the adviser has made.

Investors would be wise to ask for examples of when the adviser was wrong in their advice, what they learned, and how they’ve incorporated this experience into their advice. No adviser who’s been in this business for any material length of time will be perfect. If they claim to have a perfect record with high returns after many decades, beware! That is a common Ponzi practice.

5. Understand their recommendation for you, and its inherent tradeoffs.

In my view, a mark of real expertise is the ability to explain complicated matters in simple language. If your adviser cannot explain his or her strategy in a way you grasp, keep asking until you do. If they fail to do so, that is a red flag.

Last, what does the strategy target, and are the inherent tradeoffs explained to you? There is no holy grail in investing. There are always plusses and minuses. What are the applicable ones in your adviser’s approach?

Here again, I say, this is my opinion of the foundation of good due diligence. You’ll note a few things are absent: Referrals from friends, being in the same social group or zip code as you are. Perhaps you value those things. That’s fine. But they aren’t protections ensuring your adviser is aboveboard and competent. There is no substitute for doing your own due diligence. That was the harsh lesson Ascot Partners taught.