why its important to know your models 1

Added 26th March 2013

Charles 'Pops' Ponzi may have died more than sixty years ago, but the DNA of his investment strategy evidently lives on, says MBG Int'l managing partner Paul Gambles, in the first of a three-part series on the importance of scrutinising one's investment models.

why its important to know your models 1

As most International Adviser readers will be aware, both Ponzi and Madoff attracted new investors by promising higher-than-market rate returns, and then paying existing investors these rates with the money entrusted to them by new investors, rather than from any genuine business profits – as, in both cases, genuine profits were insufficient to cover the promised returns.

Few investment professionals today would admit they could be taken in by a modern-day Ponzi scheme, even though, as the Madoff case showed, a great many people – including some of the supposedly brightest minds in the world of financial services – were fooled as recently as five years ago.

Which is why such professionals ought to be wary.  Because the fact is that vigilance is absolutely necessary today –  as much as it was when Madoff was still spinning his story to potential new investors from his offices on Third Avenue – if similarly toxic schemes are to be avoided.

That’s because the DNA from “Pops Ponzi” is still out there, potentially lurking in the models of some investment strategies currently being marketed, if some troubling news stories in recent weeks are to be believed. 

It seems that certain characteristics of Ponzi’s approach to investment have a way of appearing in investment structures that many experts fail to examine as closely as they perhaps ought to. 

Often, as with the Ponzi and Madoff schemes, it is not entirely clear whether some of the latest crop of troubled schemes are the result of deliberate malfeasance, carelessness, or simple  ignorance. In the end, of course, it doesn’t matter, as the damage caused to investors, in the form of lost money, is the same.

The mark-to-model model

Many of the schemes that we believe should be looked at with extra attention, when they come striding down a runway towards would-be investors and their advisers, are those based on “mark to model” forumulas. These include some property investment schemes, which derive valuations purely by reference to an assumed multiple of rental values, rather than by any reference to the open market value that the property reasonably could be sold for.

Mark-to-model structures have even been known to be used in connection with investment products based on off-plan properties that haven’t been completed.

Although we hope we are wrong, it could be that in the same way that “CDO cubeds” – a super-leveraged variation of collateralised debt obligations – became symbolic of the folly behind the sub-prime bubble in 2008, hypothetical investment models built on top of poorly designed mark-to-model assumptions  will come to be seen as a symbol of the 2013 - 2014 period that future investment experts will shake their heads in disbelief over.

Readers of this publication and others will have seen references to a number of cases recently, for example, which have involved resort properties in popular vacation and retirement hotspots. The reason they are in the news is because investors have suffered when construction failed to take place within a projected time frame, and/or the resale value of comparable properties in the local market plummeted, causing the investment vehicle’s actual pricings to fall short of the developers’ – and investors’ – expectations, based on the models.

Ponzi’s scheme

Interestingly, Ponzi’s gimmick didn’t involve property at all, but what were known at the time as “international reply postal coupons”.

Ponzi promised to give investors a 50% return on their investment every 45 days, purportedly by buying these coupons at a discounted rate in countries where they were sold cheaply – such as his native Italy – and redeeming them from the US Post Office for a significantly higher face value.

Ponzi claimed such transactions yielded returns in excess of 400%.

The main thing to note at this point, though, is this: artificial pricing schemes work because, like Charles Ponzi’s original scheme, they sound entirely plausible. The stories ring true, the assets are real and recognisable, and very often, the people selling them believe they are real and a genuine good deal for investors – and thus come across as trustworthy.

To sniff out the problem, an investor has to pick apart the valuation models being used to explain current and future profits, and bear in mind the old adage that if something seems too good to be true, it almost certainly is.

Unfortunately, this is, too frequently, easier said than done.

Another defining feature of Ponzi schemes – and another reason they can be difficult to spot – is that their initial unconditional, high, fixed returns typically encourage many of the original investors to re-invest their capital and profits, rather than redeeming their holdings.

This feeds the illusion of an investment that others fear missing out on, and thus are quick to pile into, while also preventing the model from being tested by the usual market liquidity conditions – that is, normal periods of net outflows.

Most of us can still remember the aura of success that the name Madoff exuded in the months preceding the namesake company's eventual collapse – as well as the shock, subsequently, that so many well-respected financial experts (not to mention regulators) had been taken in by the scam.

Part two, tomorrow: Some common characteristics of Ponzi DNA

Paul Gambles is managing partner of MBMG International, the Bangkok, Thailand-based advisory firm

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