The Attributes of a Ponzi Scheme
- An investment opportunity promising returns greater (or better by some metric) than any other in the legitimate market.
- Distributions that are called ‘income’ when they are in fact ‘return of capital’ (ROC).
- A novice investor who does not understand the difference between ROC and income, and the implications.
- Established trust in the promoter that causes the investor to ignore any advice to the contrary.
How Does ROC Factor into Decisions ?
- Think of ‘income’ as the yearly interest you receive on a GIC.
E.g. a 5% GIC of $100,000 pays $5,000/year. - When the cash flow includes ROC, think of a mortgage.
E.g. a 5% 10-year mortgage of $100,000 pays $12,950/year. - You would never calculate the return on the mortgage as (12,950/100,000=) 12.95%. You know to ignore the ROC ($7,950), and consider only the $5,000 interest (5,000/100,000 = 5%).
Why A Ponzi Scheme Works
The scheme relies on you thinking the $12,950 cash is ‘income’. Since the market return is only 5% you will bid up the value of the investment from $100,00 to $259,000 (12,950/5%): making it easy for the scheme to finance the cash payments by selling a few more shares.
How Can You Tell ROC From Earnings ?
- If the return is greater than ‘market returns’ – it is ROC. There is no free lunch.
- If the Government tells you it is not taxable – it is ROC. Why would they just give away a good tax base?
- If the company tells you it is ROC, it probably is. Canadian Income Trusts spin this as ‘good’ news (i.e. not taxable) even while they rely on you NOT correctly factoring it out of your calculation of yield.
- Learn to understand Financial Statements. Appreciate the calculations of Comprehensive Earnings above. Also appreciate that cash flow never measures anything other that itself – not income.
- If there are no audited financials then the scheme is suspect in the highest degree.
Are Income Trusts Ponzi Schemes ?
The trusts themselves are valid operating companies. How any company decides to spend its money is completely up to them. And no one has absconded with any cash. And yet they qualify under all four criteria above. You may call it a Ponzi or a game of musical chairs. There are no losers until the music stops (no new investors can be found or someone wants their money back) and the sucker is left standing (ie. owning the units). It is the actions of the analysts and promoters who transform Trusts into Ponzi’s (by telling you the distributions are income). It is the value they are given in the market that makes them Ponzi’s (by allowing them to refinance at 50 cents on the dollar, while they turn it around and pay out distributions dollar for dollar).
