Is Your Money Safe When You Invest?

Where is your money? That is the topic today on "Informed Investor." I'm Mark Gochnour. I'm joined today by Jake DeKinder and Stephanie Hui, who is Head of Responsible Investments and? Senior Public Policy Strategist. Senior Public Policy Strategist. That's a cool title. Thank you. That's a really cool title. That's a cool title. Very cool. It's a long title. I couldn't remember all of that. It has to fit in two lines on my business card. But you are our special guest for our expert today as we talk about, you know, as an investor, how do you think about like, where does my money go? When I go buy a mutual fund or an ETF, what does that flow of assets look like and how do I have confidence, this being managed in, I'll say, a very regulated environment? So you're an attorney, you worked at the SEC. Perfect person to have this conversation with today. We got the expert in the house. All right, so here's what we'd like to do. We like a few headlines before we get into it here. So let me read a couple headlines that'll set up the conversation today. First one I wanna read. "SEC charges three with operating $91 million Ponzi scheme." That was just from a couple months ago. And then not too long ago, "SEC's public service campaign emphasizes investor protection." All right, now this conversation of investor protection, Jake, that came up a couple months ago. We were having a conference here in Austin and we had some of our clients, financial professionals, financial advisors came in and they brought their clients, so retail investors. And you and I were having lunch with one of the couples and the conversation just came up about, you know, I'm not sure really where my money goes and how do I make sure that it doesn't happen like one of these Ponzi schemes we just read about? Well, you're right. I mean, sadly, I think we do read a lot of articles like that. In fact, I read another one just the other day about a gentleman in upstate New York who had been in a small town for a long time and had been doing all types of real estate investments, turned out to be a $95 million Ponzi scheme. So it's understandable that investors get concerned about it. And it also makes sense logically. I mean, it's not like when you go and you invest, like you walk in with some big bag of cash, that normally doesn't happen, and say, "Okay, invest my money," right? You're on a computer, it's an electronic transfer. It's like the money's just gone. So I get it that people want to know, "Okay, I'm reading about all this stuff. I've heard about the same mutual fund and ETF. How do I know that my money's safe when it goes there?" Yeah, what are the checks and balances in place? What's in place? What are some of the policies, some of the regulations in place? So perfect segue into Stephanie here and really, I'll say the umbrella to all of this goes back to the SEC and the Investment Act of 1940. So just give us a little bit of background in terms of how that came about, why it's important, and then we'll dive into just some of how does that money flow from there? Yeah, so as you said, it all goes back to the Investment Company Act of 1940, but pop quiz on history, do you know when the first investment company was formed? Investment company, meaning a mutual fund? I'm going 1920s. I think you're right. You guys are right. 1924. Boom. Did you see how, we gave a wide range. 1924 to be specific. The '20s. 1924 and then five years later in 1929, what happened? What was our big event then? Great Depression started up, didn't it? Crash. The stock market crash. The market crash. Yes. And then, yeah, yeah. But leading into the Great Depression. Yeah, yeah. Exactly. Yeah. And so that is the frame, or that is the backdrop of the 1940 Act. And so the Securities and Exchange Commission was formed by an act of Congress in 1934, and then Congress asked the SEC to look into mutual defense and what went wrong. And so in the '30s, there were a number of different studies that the SEC did and they had a number of conclusions. One of the big ones was that investors didn't have enough information about the investments that they were making. So that was a huge takeaway for them. And another one was that there was a lot of stealth dealing. So we had a manager who was running a fund, they were investing in a custodian who was their buddy. They had another buddy who was auditing them. It was just a lot of self-dealing and a lot of, there was no independence, basically. A lot of conflicts between those three. A lot of conflicts. Exactly. So if you look at the '40 Act, so much of the '40 Act is meant to eliminate or disclose those conflicts. It's meant to make the funds more transparent. There's more reporting. Liquidity was another issue. And so there's the ability to redeem your shares every day. So a lot of what went into the '40 Act and all the rules that mutual funds and ETFs have to comply with now all go back to a lot of those problems that were happening in the '20s and '30s. And it's all designed to, how do I make the most informed decision as an investor as I can, ultimately, all those things you just described there. Exactly. The '40 Act isn't meant to say what's a good investment or not. It's meant to just give you the information you need to be an informed investor. Okay, great. One of the things that was part of the 1940 Act, and we'll call it the '40 Act. And when we're talking about that here, we're gonna talk about mutual funds and ETFs, right? Both of those fall under the '40 Act, right, okay. Exactly. Yeah. One of the things that came outta that was the role of the independent board of directors. So maybe just talk a little bit about that independent board and what they do when it comes to, let's say a fund manager, an asset manager, like Dimensional. Yeah, sure, so an investment company, it's a company, of course. And so like any company, you have to have a board of directors. The fund is a separate legal entity. That's one big takeaway. And so the fund, this investment company then hires a manager to manage the assets in the fund. And so the '40 Act, you have to have an independent board that oversees what the manager's doing and it's meant to be a check and balance. Like you're making sure that the manager is appropriately managing the money, they're charging a fee that is reasonable for the services that the manager's providing. And that's a very robust process. And every year, the board of directors has to review the advisory contract between the fund and the manager. All right, so the board essentially hires the manager every year. They go through that process. And effectively, the board is holding the manager accountable, is how I think about that. Is that a reasonable way to think about that? Yeah, and looking out for the interest of the shareholders. For the benefit of the shareholder. Exactly. Absolutely. Okay. So that's one important part of it. And another part of it, when it comes back to say avoiding conflicts, from the 1940 Act, is then a fund custodian, an independent fund custodian. And that's where the assets are actually held. So how is that, sort of going back to your example there in saying, before the market crash where you had, okay, a manager whose buddy was a custodian whose buddy was an accountant, what's the separation now between the custodian, the fund custodian, and the manager? Yeah, now, under the '40 Act, a fund has to hire a qualified custodian. It's a defined term and it's usually a bank that's regulated by the banking authorities. That is the one that holds all of the securities that the fund invests in. So the manager doesn't actually have the money, meaning like an asset manager, like Dimensional, doesn't have the money. Right. It's not in our account. It is at the fund custodian. Okay. Yeah. So we don't have the ability to pull the money out, if there's a concern about that, right? We have the ability to trade on those, that account. So we can go buy and sell securities, stocks or bonds, but we can't get money outta their Dimensional account. Exactly. Okay. And that's the independent control that's in place there. Another one that's really important in that process, just we want to get all the major players out there, a transfer agent. So what's a transfer agent do? Well when you go in there, this fund, this pool of assets, okay, well, there's gonna be a whole bunch of shares then. And so the transfer agent tracks those shares of all the different entities. So they'll say, okay, let's just say there's a million shares of a mutual fund. They'll know then that, okay, so many of those shares go to an investor's custodian, like a Schwab, so many might go to Fidelity, so many go to these other places. So that's a valuable role. They're tracking all those shares. And then of course the auditors, the accountants are incredibly important in that one as well. Which by the way, I used to be an auditor at Deloitte & Touche So this speaks to my heart there. You say it so proudly. You name dropped. Super important. That's right. But go back to again, your example there, like the auditor in your original example was, you know, they weren't necessarily independent, so they have a huge role today in a regulated environment, don't they? Yeah, and they have to go in and make sure that all the securities and cash is there in the fund custodian's account, there are surprise audits that the fund doesn't know about when they go in and make sure everything is there. All right, so those are the major players. You got the manager, who's hired by the fund. You got an independent fund custodian, where all the securities are held. You got the transfer agent and then the independent auditor. So if I'm an investor, so I've got 100 grand to invest, I'm an investor, so how does my money get into the fund? How does that work? So let's say you open an account at, you know, a brokerage, Fidelity or Schwab, you put your money there and then you say, "I wanna invest in X, Y, Z fund." Then that money would get sent to the fund custodian and managed there. So if I'm an individual investor, and just for an example, and you named a couple, you know, big custodians that people may know, that's where I'm getting my statements from. Right? Exactly. Okay, and then they're interacting with the fund custodian and that part, what if I have a financial professional? What if I work through an advisor, at least at a high level? Does the process work generally the same way? Yeah, generally it's exactly the same. You still have your account at, your individual account, and then if you're investing in fund, the money eventually goes to the fund custodian. Okay. All right. Now in that case, the advisor may place the trade- That's right. On behalf of the client, on behalf of the investor, so. Right. Just one thing we'll want to talk about that too is just, for any investor, if you give trading authority to somebody, just make sure you know exactly what all is being given up there. That's a great point. Sometimes they can transfer assets between different accounts. Just every investor should know. That's a great point. What that looks like there. Yeah. A couple, I'm gonna call 'em key features, I want to talk about that came out of the 1940 Act as well. One of the questions we get is, "Hey, when I redeem my money, meaning I ask for my money back, what's the timetable around that?" So just give us a little overview on the timing of that as it's defined in the 1940 Act. Yeah, so liquidity is a real key of the '40 Act. And so if you, you have to have daily redeemable securities, if you're a fund under the 40 Act. So if you ask for your money back by a certain cutoff time, then the fund has to give you that day's price. They have to strike NAV every day and value how much the portfolio is worth. So NAV is net asset value. It's yeah, the end of the day, here's what that mutual fund or ETF's worth. Exactly. Mm-hmm. Okay. The other thing I want to ask about too is, what if a manager goes under? Whatever happens in their business model and they see cease to exist as an entity, what happens to the securities then? Well, as we talked about earlier, the fund is a separate legal entity from the manager. So the fund is still there, it's got all their securities still at the fund custodian. So if the manager that the fund has hired goes under, it doesn't really affect the fund. What the fund has to do, though, is go out and find a new manager to then manage their assets. So the board would get involved, they would go through that same process, and hire a new fund manager. Well the separate legal entity too, I think, is surprising for investors when we bring that up, that a fund is a separate legal entity. It's a company, right? And that, I think, does surprise people. And then the independence around that. And the independence, and that's why you have the independent board, yeah. Yeah. From the board, which is independent from the custodian. Completely. Which is independent usually from then that, I'll say the investor's custodian. Yeah, yeah. And the auditor and all that stuff there as well. All right, I'm gonna play a what about game with you guys. I'm gonna ask a couple, "Well yeah, but what about X, Y and Z?" So here's the first question that I want to ask with that because what we're talking about here is a regulated environment, which is gonna be publicly traded stocks and bonds. But what about something like private equity or private investments? We often hear about that. How would I think about that relative to what we just talked about? Yeah, I think, well you brought up some good things about the '40 Act. I mean, one of the points I heard you make was this idea of getting the information that investors need, right? And we should be really clear, as we're talking about private market, there are regulations that are in place within private markets, right? So we're not saying that. But I like the point you brought up about getting the information and I think once you go to private markets, it can be at times just maybe a little bit more burden on the investor to get some of that information. You talked about striking daily NAV, net asset value. You know, as you go to the private markets, those things may not be priced every single day. You may not know what that stuff's worth at the end of every single day. And then you talked about daily liquidity, the ability to get your money back. I mean once you go to private markets, you gotta understand that if you ask for your money back today, they don't necessarily have to give it back right away. Right? There can be timetables set up. There can be amounts that can get up, there can be lockup periods, and that's the nature of private investments because they can be more illiquid investments many times. So this is not a fault of the manager within private, it's just, you're moving from one part of the investible universe into a different part of the investible universe that moves away from the '40 Act and some things that you've gotta understand as you start to go that direction. Yeah, there may be reasons why they're doing that. Completely, completely. It's just as an investor, you gotta be crystal clear- That's right. On what some of those liquidity constraints may or may not be. Right. Around that. All right, I got another one for you, Stephanie. And this goes back to the headlines we were talking about, like a Ponzi scheme. Let's talk about, I think the biggest one, probably most people are familiar with. Madoff, like what happened with the Madoff that would've been different than what we were just talking about in a regulated environment. Well first of all, Madoff was not running a regulated investment company. So it was not a registered- I think we're all clear on that one. It wasn't a failure of the system. Let's be clear about that. Yeah. So a lot of the things that you would see with a mutual fund just didn't happen with Madoff's scheme. So for example, the custodian, he didn't have an independent custodian. I think I read that he actually was depositing checks into his own bank account. The independent auditor, that's another one that he didn't have. He had like a two person auditing firm, which I think was his buddy or someone. He was affiliated with- Affiliated. The funds about, yeah. He's also investor. So he stood to gain from this Ponzi scheme as well. And so he was an independent. There's no independent custodian, there was no really independent auditor. And then the other one that was a big one after the fact is that there were no online statements, performance statements. I think they were mailed out to their clients and they were sort of hard, I think, to follow. But to be able to go and say, "Hey, I wanna know exactly what my performance was in individual holdings," I don't think that was necessarily available there on any sort of a digital format, which is a characteristic, I think, of any probably independent custodian that's out there. Certainly in this day and age. Yeah, in this day and age for sure. All right, here's a couple things I was thinking about. And if I'm an investor then, like how do you know? Kinda going back to how do I know perhaps what the liquidity environment is for a particular private investment maybe versus something in a more regulated environment. So I'm gonna read a couple, I'll say questions or maybe things you wanna make sure you do as an investor and then you guys can add any more to them or clarify anything that I say here. So a couple things here. I think one, as an investor, you always want to know who the fund custodian is and make sure they're independent. You always want to know there's gonna be audited financial statements from a large independent accounting firm. So I think for any of those you can ask for independent, or sorry, you can ask for the audited financial statements. It goes back to being informed about the overall strategy. I'm sure that many of these investments have a prospectus. You certainly have to have one under the '40 Act. Get the prospectus, make sure you understand what the strategy is, the fees associated with the liquidity, about the ability to pull money out, what that looks like, which is kind of my next one around redemptions. And then yeah, your statements, your performance statements, what do those look like? Make sure you can access those in a digital format in any kind of environment there. So those are the ones that jump out to me. Anything you guys would add to a couple of those key things as an investor you want to know? I just think it's a good reminder that when you approach any investment you want to have sort of logical questions prepared. A couple episodes ago, when we were doing this, we talked about, hey, you know, before you put money to work, you wanna think about what's the goal, kind of, you know, expect return, what you think you're gonna make, what's the risk associated with it, what's the cost associated with it? And as you're talking about, you know, understanding where your money goes, I think those are logical questions you want to ask. Know the key players, make sure they're independent. That's right. And you know, the last thing I'm gonna say here, and I do think this is a, an obligation every investor has, is be skeptical about any investment you're getting into, regulated or not regulated. This idea, does this sound too good to be true? Mm-hmm. And Jake, you and I say this all the time, if it sounds to you to be true, it usually is, especially when it comes to your money. If you're hearing something like, "Hey, yeah, you're gonna get eight to 10% every year," that's just not how markets work. Stocks or bonds, prices ebb and flow, returns ebb and flow. So something that just sounds that good, just be skeptical. Make sure you understand all the different aspects we talked about here today. I think that's really good. Actually, that article that I referenced on that upstate New York $95 million Ponzi scheme, I think they actually called it the 8% fund. The 8% fund? The 8% fund. And again, I mean, look, the people that are invested in that. I mean that's really tough, right? That's real money. And so I think it you're spot on that if it sounds too good to be true, you want to do your due diligence, you want to ask the questions, you want to understand how everything's working to the best of your ability as an investor. And if you feel a little bit overwhelmed by that, a financial professional, a professional advisor- That's a great point. Great point. Can help you work through a lot of that as well. They got a lot of expertise, a lot of guidance on those kind of choices. Stephanie, thanks for joining us here today. Appreciate your time- Thanks for having me. And expertise around that. Super helpful. And Jake, one of the things you were talking about there earlier were private investments. We get quite a few questions about that and kinda where it fits into my portfolio. So that's going to be a future episode on "The Informed Investor," private investments. Thanks again for joining us here today and be sure to hit the subscribe button. Thanks everybody, have a great day.