Broker Failure Highlights Need For Vigilance

Collapsed futures Peregrine Financial Group Inc. shows futures brokerage industry is still very risky and needs better regulation. Futures brokers are called “futures merchants” and are different from securities Broker-Dealers. Fortunately securities investors are much more secure because they are protected by strict audits of securities Brokers and are protected by SPIC insurance up to $500,000. By contrast, there is no insurance protection for futures brokerage accounts. Apparently the audit process for futures brokers is very poor or else the collapse of Peregrine Financial Group Inc. and MF Global would not have happened.

I prefer to recommend mutual funds that invest in securities and to avoid investing in futures contracts, including avoiding ETN’s that invest in futures contracts. Mutual funds have their assets held by a Transfer Agent which is a bank. The bank is regulated and audited by the government and is audited by an outside CPA. The mutual fund shares are held at a Broker-Dealer where SIPC insurance protects the account up to $500,000 in the event of a brokerage collapse.

The collapse of the two futures brokers should alert investors to be vigilant against fraud and poor internal controls. Investors should recognize the value of using multiple layers of watchdogs that are different parties, to look over their assets.

Ironically losses from investors buying overpriced bubble stocks is worse than loss from fraud. Therefore investors need to be self-aware of the need to avoid bubbles, over-priced investments, and excessive investment fees including early redemption fees, surrender charges, etc. Whenever bad news like Peregrine Financial Group Inc. failure occurs investors can benfit because they will be inspired to learn to be on the alert.

Steps to protect yourself:

- Avoid risky bubble investments; instead invest conservatively

- Avoid overpriced investment services like mutual funds with excessive fees

- Avoid investments where one party has all the control. This means using layers of different entities to keep an eye on your investments. For example you could hire an RIA company to advise you on investments and then hold the investments at a Custodian who is a Broker-Dealer. Further the investments could be mutual funds so that the fund’s employees are examining the investments, the fund company gets its books audited, the fund company has the assets held at a bank Transfer Agent where additional auditors examine the bank’s records.

- Avoid risky commodity futures, ETN’s, ETP’s. Simply own (shares of mutual funds that hold) unleveraged assets like stocks and bonds.

About the author

Don Martin, CFP®

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