Having watched the hit movie The Wolf of Wall Street recently, I have to say: racy, entertaining — but nothing new. There will always be wolves lurking on Wall Street – both real and Hollywood-drawn. The main thing is that in real life the wolves are the exception (not the rule) and seeing them coming is the best way to avoid being their next victim. Here’s how we do that.
Jordan Belfort, the real-life wolf played by Leonardo DiCaprio, was (and still is) a really good salesman, who made millions hyping “penny stock” IPOs (Initial Public Offerings). Granted, the IPO market for penny stocks (equities priced under $5/share) tends to attract snake-oil salesmen. But…the IPO process overall is legit, and it does a good job of providing financing to thousands of companies every year.
Here in Seattle, we’ve continued to benefit from a long line of world-changing IPOs, including Microsoft, Starbucks, Amazon.com, and most recently Tableau, Zillow.com and Zulily. IPOs have created tremendous real wealth for our region, not to mention changing how people live and work.
Diligent Due Diligence
Probably because I’m a client analyst here at LNWM, for me the bigger issue raised by The Wolf of Wall Street is: how can you avoid being financially mauled by the next Belfort?
Earlier this week, I was talking with three of the members of LNWM’s Investment Strategy & Research team (ISR). And I asked them how LNWM has avoided Madoff/Belfort fiascos.
Their response: It’s because of our in-depth due diligence. And this is an on-going process. We do checkups on all our asset managers at least quarterly and immediately if we detect a problem. If we see any orange lights — the slightest indication that something or someone might not be on the level — we steer clear.
The Alternatives Universe
One of ISR’s specialties is doing due diligence on alternative investments, which we add to client portfolios to optimize diversification and risk-adjusted returns. Included here are hedge funds, private equity funds, and other types of limited partnerships that invest in things like real estate or commodities.
Alternative investments require extra due diligence. Managers sometimes don’t want to deal with our research requests. And that’s the end of that conversation. Some of the things our ISR team do:
Get to know the managers, as well as how they invest. LNWM will spend a considerable amount of time researching the investment team and their support, in addition to understanding the performance results.
Dig into the numbers. LNWM goes beyond quarterly performance reports to really understand where the returns were generated, and if the successes (or failures) could be repeated. We also read through many years of audited financial statements for additional clues, like how much the manager was paid in fees, how onerous the administrative charges were, and if they had to write anything off – a “loss due to fraud” footnote would certainly lead to more questions.
Onsite visits to verify process and investments. After spending weeks culling through the manager’s documentation and performance record, LNWM will frequently spend a day or two at a manager’s office making sure what they SAY is what they DO. We’ll ask for a random sample of investments in the portfolio and evaluate the depth of their research.
“We like to see a standardized process, and then we test that process. If we can’t get a clear understanding of their underlying positions, and we can’t go into their offices to test the investment process and positions, we don’t invest,” says David Baker, ISR team member.
Look at the manager’s “soft-dollar” policies. Essentially, these are barter agreements between asset managers and broker dealers or other service providers; for instance, access to research reports in exchange for slightly higher trading commissions. Soft-money deals aren’t necessarily bad, but we’d rather not see them. We always want our managers to bargain for best-possible trade execution at the lowest price.
Good old Form ADV filed with the SEC. ISR also pointed out that most alternative-asset managers are Registered Investment Advisors (RIAs), meaning they’re regulated by the Securities & Exchange Commission. So you can go to the SEC website to find their firm’s Form ADV. This form contains any sanctions, violations, misconduct of the firm and its employees.
However, the particular alternative investment being offered may not be regulated by the SEC. If that’s the case, says ISR, the managers have a lot more to prove.
UPDATE: Here’s more proof that there will always be wolves on Wall Street: http://blogs.marketwatch.com/thetell/2014/03/27/job-searches-for-stockbroker-rocket-after-the-wolf-of-wall-street/