How do you know whether the investment into which you have been invited (or pressed) to put your hard-earned money is reputable or a Ponzi scheme?
First, you should check whether it has the credentials of a solid investment – for example, whether it is registered under the Collective Investment Schemes Control Act if it is a collective investment and whether the person offering it to you represents a financial services provider registered with the Financial Services Board (FSB).
Second, you should ask the question any financial professional would recommend you ask: “Does it sound too good to be true?” But what is “too good to be true” in terms of investment performance?
In a recent article, “Ponzi or honest investment scheme?”, Hannes Viljoen, the senior manager of technical solutions at Investment Solutions, looks at the difference between genuine returns made by market-based investments and those a Ponzi scheme would be likely to offer.
“The easiest way to identify a Ponzi scheme is by looking at the returns already earned, as well as the future investment growth promised. According to the Consumer Protection Act, any scheme that offers returns of 20 percent or more above the repo rate is, in essence, classified as a Ponzi scheme. Currently, this would be a return of above 27 percent a year,” he says.
Viljoen says returns earned in the South African market over the years provide a ballpark figure of what can reasonably be expected of an “honest” investment.
“South Africans who were invested in equity assets (shares on the JSE) have done extremely well over the past 15 and 25 years, earning above-inflation returns of 10.5 percent and 9.4 percent respectively. If they were fully invested in property over the past five years, they would have earned close to a phenomenal CPI plus 14 percent a year.
“However, an average compounded return of more than 20 percent a year has never been earned in any of the above-mentioned asset classes over medium to long periods (although returns of more than 20 percent in a particular year have been achieved), never mind the inflation or repo rate plus 20 percent. And the consensus is that the phenomenal past returns in the local market have little chance of being repeated in the near future, especially given the current circumstances and value of the market,” Viljoen says.
So if you are offered returns above these (schemes may offer outrageous returns of, for example, 20 percent a month or more), warning lights should start flashing. Viljoen says they should flash even brighter if the word “guaranteed” is used. The only institutions that can guarantee returns are large banks and insurers.
You should also investigate how the returns are made.
Investors typically measure the success of an investment by its outcome, Viljoen says. “What they don’t see is that the path to that growth is as important as the growth itself. Investors need to dig a bit deeper to understand where the investments derive their returns.
“When the source of funds or earnings is a ‘donation’ from a third party, as with some schemes recently unveiled, you should ask questions. Donations are not a normal source of earnings. Unsustainable sources of earnings are just that – unsustainable. They will eventually dry up and the scheme will fall flat,” he says.
THE ORIGINAL PONZI SCHEME
The first Ponzi scheme is attributed to an Italian, Charles Ponzi, who, in 1919, promised to return US$15 to anyone who lent him $10 for just 90 days (a compounded annual return of slightly more than 400 percent). His investment strategy was simple: he would buy foreign currencies at low prices and sell them at high prices. According to records, Ponzi took in $15 million in eight months and paid out less than $200 000 to investors, which summarises the nature of a Ponzi scheme: paying returns to existing investors from capital received from new investors rather than from profit earned through the legitimate investment of capital. In layman’s terms, Peter’s investment is used to pay a return to Paul on his original investment. – Hannes Viljoen