How to spot an investment that might be too good to be true

How do you know when an investment opportunity might be too good to be true? Sometimes it’s tough to tell.

Unfortunately, the investment industry is rife with unscrupulous actors. 

In 2022 alone, consumers lost almost $4 billion to investment scams, more than any other fraud category. And that only accounts for outright fraud. It leaves out investment offerings that over-promise or hide risks to entice investors into products designed to make more money for the provider than the investor.

Over my career, I have either invested in or assisted with the due diligence on all kinds of investments, including private loans, real estate, hedge funds, private equity, and more. 

Certain best practices are in place for these kinds of alternative investments when reputable firms market them to sophisticated investors. When you look at enough of these kinds of deals, you start to see specific patterns that can either give you comfort or serve as major red flags. 

If you are looking at a non-traditional investment, here are a few of those red flags you might want to watch out for. It could be the difference between keeping your money safe and falling for a scam.

Too good to be true?

First, you should be suspicious of any investment product or strategy that promises outsized or market-level returns without risk. It may seem like basic advice, but if it sounds too good to be true, it probably is.

Here’s a good rule to follow: above-market returns will only come from above-market risk. This means that any investment offering the potential for very high returns likely has the potential for significant losses. 

The opposite is true, too. If an investment product promises lower risk, you should assume it also has lower returns.

This balance of risk and reward should be clear when considering an alternative investment. You might ask the firm offering the investment to describe a scenario where the strategy doesn’t work or what circumstances would cause its value to decline materially. They should be able to give you a simple and plausible scenario that is likely to occur. 

If they can’t, or if the only scenario they give you seems outlandishly unlikely, that’s a red flag. The firm itself might not understand the risk they are taking, or they could be hiding them from you. If either of those are true, you don't want to be involved.

Follow the money

Any financial services provider, including your bank, an investment manager, or even Facet, is a business trying to profit from their service. An honest firm will make it very clear how they are making money from your investment. 

A lot of alternative investments charge relatively high fees. However, good firms outline these fees in their investment documents in plain language. You can decide if those high fees are worth paying or not, but it shouldn’t be a mystery what you are being charged.

If you are struggling to understand how the firm offering the product makes money, be suspicious. We have seen a number of “investments” where the firm claimed they weren’t charging any fee at all. While that was technically true, if you read the fine print, you find out that the firm is actually taking risks with your money and promising you a piece of the profits. In other words, if the investment made money, you would both win. But if the investment doesn’t work, you lose your money, and the firm walks away.

If a firm makes it hard to understand their angle, it’s best to assume they don’t want you to know. That’s not someone you should do business with.

Are the right kinds of people involved?

Many of these alternative investment types are relationship-based businesses. Who you know is a big part of success in the venture capital, energy investment, private equity, and real estate worlds. These kinds of investments don’t trade on an exchange, so for firms in these industries to get access to attractive deals, they generally must have a relationship with the seller.

For example, in real estate, when a large apartment building is for sale, not every real estate firm in the whole world gets a chance to bid on the building. The seller doesn’t have time to sort through thousands of bids, negotiate the various terms, determine which have secure financing, etc. These kinds of deals are typically marketed to a small handful of investors, generally the same investors that the seller has dealt with in the past.

This means that to succeed in these kinds of investments, the firm involved must have the right connections. The well-connected firms get the first crack at the best deals, and everyone else gets the leftovers.

So, when looking at these kinds of investments, dig into the background of the principals involved. Also, consider the buying power of the firm making the offering. Do they have the connections to get their first choice of investments? Or are they getting the scraps?

Guarantee doesn’t mean guaranteed

Another major red flag is around the word “guarantee.” Unscrupulous firms know that word triggers your brain to think of safety. 

Unfortunately, the term “guarantee” can legally mean various things. For example, when your bank says that your deposit is guaranteed by the FDIC, that means that another entity is promising to backstop your deposit in case the bank goes out of business. 

However, the same term might mean merely that an investment intends to pay out a fixed amount. For example, a guaranteed annuity from an insurance company simply means that it must make those payments to you as long as it is in business. It doesn’t necessarily mean anyone else is backing up that guarantee. 

Now, the good news with insurance companies is that they are heavily regulated and required to set aside large amounts of assets to back up those guarantees. However, you can see that this guarantee isn’t the same as the FDIC standing behind your bank deposit.

The world of private investments is much less regulated, so less honest firms may use the word “guarantee” more loosely. 

To see what we mean, we recently came across an investment promising a 15% “guaranteed” return. Suspicious, we dug into the documents. 

It turned out the investment was just a loan to a real estate company to buy up distressed properties. If the company made enough profit on those properties, they had to pay the 15%. If they didn’t, nothing else backed up the 15% claim. 

In this specific case, investors wouldn’t even get to sell off the properties to try to recoup some of their investment. It would have been wiped out.

While this might fit some technical legal definition of “guaranteed,” it certainly isn’t how anyone would use that word in normal conversation. Unsurprisingly, the 15% return is very much at risk. 

A reputable firm wouldn’t try to fool you by using words likely to be misconstrued. If an investment is sold using words like “guaranteed,” you should be highly skeptical.

Past performance

The famous saying is true: past performance is not indicative of future results. However, that doesn’t mean that past performance is meaningless. A firm that accurately measures performance shows a certain level of transparency and accountability. If a firm tells you its investors have made money, you should be able to ask for proof. 

Beware of firms that purport to show past performance, but in actuality, that performance is getting backdated. For example, we recently encountered a firm trying to sell a Facet member on a series of private investment funds. The proposal included past performance data, but the performance was based on the funds currently proposed. 

That alone can be useful information, but it isn’t enough. Anyone can pick five or six funds that have performed well in the past. However, it doesn’t indicate they have any skill in selecting private funds. 

What you need to know is what would have happened had you become a client three or five years ago. What funds was the firm recommending then, and how have they performed?

Reputable firms track performance data this way because they know sophisticated investors will insist on seeing it. If a firm can’t (or won’t) show you how an actual client would have performed based on real-time decision-making, that’s a bad sign. It likely means they have no intention of marketing their strategy to sophisticated investors in the first place. 

Why are they marketing it to you?

The marketplace for private and alternative investments is massive. Equitable estimates public pension funds have invested over $600 billion in alternative assets, and college endowments have invested $480 billion in alternatives. 

These are just two examples. There are vast pools of capital looking to invest in alternative assets among these large, sophisticated investor types.

I have worked closely with these kinds of large investors over my career. They often have in-house investment staff who do nothing but conduct due diligence on private investments. They hire outside consultants to help with their analysis, conduct lengthy interviews, crunch reams of data, and run deep audits on an investment firm’s policies. In other words, surviving this kind of scrutiny isn’t easy.

The reward for firms that can pass the diligence test is access to these immense pools of capital. Gigantic pension funds, endowments, foundations, and billionaire family offices may write investment checks of $100 million or more. The best firms in the alternative space all want a shot at these investor types.

So, if you are being offered an alternative investment as an individual, ask yourself why. If an investment is so amazing, why not sell it to the $16 billion Ford Foundation? Or the $400 billion California Public Employees Retirement System?

Of course, there could be good reasons, but it could also be simply because they know they can’t survive the level of scrutiny these large accounts will put on the investment strategy. It might be that the firm selling the investment is more comfortable marketing to investors who don’t have the ability, knowledge, or experience to dig deep into the strategy.

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

Warren Buffett

When trafficking in alternative investments, there are a lot of sharks out there. Be sure you aren’t the prey.