Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Ross Asset collapse setback for FMA

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Company lacked inherent checks and balances to protect investors.

People should invest through a structure where the assets are held by an independent custodian. Photo / Greg Bowker
People should invest through a structure where the assets are held by an independent custodian. Photo / Greg Bowker

The collapse of Ross Asset Management is a stark reminder that people should be extremely careful with their investable funds.

The company, which is owned and managed by David Ross, had 900 investors with a purported $449.6 million of assets, an average of $500,000 per person.

These individuals face total losses of $439.4 million before legal, consulting and receivership fees as PwC has identified only $10.2 million of assets at this stage.

RAM has many of the characteristics of Hubbard Management Funds, although the latter had purported funds of only $70 million.

These similarities include: a strong bias towards small, high-risk mining stocks; reliance on one individual with no back-up investment expertise; inadequate accounting practices; Ponzi scheme characteristics.

The lessons from the Ross and Hubbard debacles are that investors should invest through a structure where the assets are held by an independent custodian.

Under this structure, payments and receipt of monies are all handled by the custodian company on behalf of the investor with no money paid directly to the investment manager.

In addition, the investment management company should not be reliant on just one individual. It should have a number of experienced investment personnel and should not have a concentration of small, high-risk mining stocks unless an investor specifically requests such a high-risk investment strategy.

It is important to note that Ross and Hubbard were complete outliers. They operated in a totally different way from most investment managers, including KiwiSaver managers.

Most investment managers, unlike Ross and Hubbard, have independent custodians, audited accounts and independent pricing and returns analysis. Individuals should look for these features when entrusting their money with an investment management company.

David Ross, who is from North Otago and went to Waitaki Boys High, was the co-owner of Wellington-based Leadenhall Investment Managers with Peter O'Neil in the 1980s. Ross was a portfolio manager with a strong bias towards minor, high-risk companies, particularly in the mining sector.

Leadenhall performed particularly well during the 80s and was one of the country's highest-profile and fastest-growing financial services organisations. But it had serious problems after the 1987 sharemarket crash because it had invested in too many small, risky companies with limited liquidity. It also had a sub-standard property portfolio and poor administration.

O'Neil bought out Ross and Leadenhall was acquired by Southpac Investment Management in 1990 for a nominal sum. Essentially, Southpac bailed out the ailing Leadenhall.

Wellington-based Ross Asset Management was formed in late 1989 and has two shareholders, David Ross and his wife, Jill. Ross managed money for individuals on an individual portfolio basis without using an independent custodian.

Investors deposited funds with RAM, assets were purchased and sold on their behalf and held by RAM. The investment performance of these funds was reported by RAM without any independent verification or audit. RAM clients had their own individual portfolio and, as a consequence, could have widely differing investment returns.

This administration structure was used by the infamous Bernie Madoff in the United States, by Hubbard Management Funds and by Mike and Jacqui Bradley in Auckland. Jacqui Bradley was recently sentenced to seven years and five months in jail for defrauding 28 investors of $15.5 million in a Ponzi scheme.

PwC's report to the High Court clearly identified RAM's poor administration structure. The company's records show $437.6 million of the purported assets of $449.6 million were held under the name of Bevis Marks.

These assets were purported investments in 207 listed securities in Australia, United States and Canada. However, there is no record of broker transaction statements, portfolio valuations, broker contract notes or registry records in relation to the Bevis Marks' investments.

Nor is there any record of these holdings in publicly available securities registers, even though a number of them would be in a company's top 20 shareholders list.

PwC wrote: "To date we have not been able to verify any material portion of these investments ($437.6 million in Bevis Marks) with external sources and there is a lack of supporting evidence in the group's records in respect of these investments".

Nevertheless RAM had an asset database which "shows the name of each security and the volume stated to be held by each investor along with the purported location and market valuation".

The total value of these holdings is alleged to be $449.6 million, even though PWC has found almost no record of the $437.6 million supposed to be held in the Bevis Marks name.

Based on the PwC report, it looks as if Ross could have been running a Ponzi scheme whereby a manager reports false and inflated returns and pays out these false returns to investors from contributions made by new investors.

For example if an individual gave RAM $1 million and Ross reported returns of 30 per cent in year one and 25 per cent in each of year two and three, then this $1 million would be worth $2.03 million after 36 months.

However, if the actual returns were 30 per cent followed by two annual 10 per cent returns then the portfolio would be worth only $1.57 million. Thus, if RAM paid out $2.03 million after three years it would have to take $460,000 from other investors ($2.03 million minus $1.57 million).

This is a classic Ponzi scheme whereby the payout of an inflated return to one investor comes from the capital contributions of new investors. The problem with such schemes is they quickly gain momentum because managers have to keep reporting high returns, even if they are false, to attract new money in order to meet withdrawals.

Based on the information contained in the PwC report, RAM may have been reporting false returns and funding withdrawals from new contributions for some time.

This could lead to potential litigation as investors who have lost money in RAM may make claims against those who have withdrawn their funds on the basis that these withdrawals have come from the litigants' capital contributions.

Individuals who invested in RAM in recent years could have a particularly strong case in this regard.

The collapse of Ross Asset Management is a big setback for the newly formed Financial Markets Authority as it approved David Ross as an Authorised Financial Advisor (AFA) and the regulator is supposed to have oversight of investment management companies.

The RAM debacle will probably lead to more vigilance and intervention by the FMA in the investment sector.

However, it's important to note RAM was a complete outlier, its structure radically different, and inferior, to most other investment managers.

It didn't have the inherent checks and balances to protect investors against deception or fraud.

The accompanying table shows the two main investment management structures in New Zealand and RAM.

One is Portfolio Investment Entities, which include KiwiSaver funds. the other is traditional individual managed accounts where individuals have their own individual portfolios.

These two structures have a number of checks, particularly independent custodians which should be an absolute requirement, although an investment management company and its custodian may have a common owner as long as the two entities operate separately and have individual audits by reputable and independent auditors.

RAM, like Hubbard Management Funds and the Bradleys, did not have an independent custodian. Investors need to be extremely careful about the lack of an independent custodian, particularly when fantastic returns are being reported.

The only major difference between RAM, Hubbard Asset Management and the Bradleys is that David Ross was a qualified AFA whereas the other two organisations collapsed before the AFA regime was introduced.

The FMA will have to reassess its AFA procedures to make sure individuals don't use this qualification to attract funds to their flawed businesses.


Brian Gaynor is an executive director of Milford Asset Management.

bgaynor@milfordasset.com

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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