With the current news about Ponzi schemes and crooked investment managers, people are asking me how they can avoid being Bernie Madoff'ed. I've been in the investment management business (but no more), and I've read the stories, and I think I can offer some good tips.
As you have no doubt figured out already, personal references don't count for much. The crooks have already charmed your friends. References may protect you from the fly-by-night flim flam men, but you are not protected from the roots-in-the-community schemers.
One protection is to use a stock broker from a respected firm. The brokerage has its own fraud controls in place, and it has deep pockets if your broker does defraud you. It's sometimes hard to get to those deep pockets, but the worst cases usually don't occur through stock brokers.
A sure fire protection is to do your own trading. You can pay a financial planner or investment advisor a fee, but then do the trades yourself in your own discount brokerage account, or directly through mutual fund companies. You'll get the benefit of professional advice, and excellent protection against scams. However, you have to have the discipline to actually carry out the trades your advisor recommends. If you let things pile up, this is not a good approach. One thing a professional investment advisor does for you is to actually get the trades done.
The best protection against Ponzi schemes run by investment managers is a respected third-party custodian. Here's how that works. Say you have selected an investment manager. He will have you open an account at a brokerage firm such as Schwab or Fidelity. You'll sign papers giving him a limited power of attorney. He'll be able to trade stocks and bonds, but he will not have the authority to take money out of the account. Every month you'll receive a statement from the brokerage–directly from the brokerage, not through the investment manager–listing your assets. You have 100 shares of Apple, 200 shares of Boeing, etc.
When opening the account, you'll typically fill out the brokerage's new account forms, which will be supplied to you by your investment manager. He may even fill them out for you, to make the process easier. However, I recommend that you call the brokerage company yourself and ask two specific questions. 1) Who has authority to withdraw cash? and 2) Who has authority to change the address to which statements are mailed?
The first question is pretty obvious; only you, not your investment advisor, should have the authority to withdraw cash (or stocks or bonds). The second question is equally important. There have been scams in which the investment advisor listed his own address to receive the client's statements. Then he prepared phony statements that looked just like the brokerage statements, but which misrepresented the client's positions. So make sure that only you can change the address that the brokerage mails statements to.
There are two challenges to this system. First, the investment manager may want to invest in a private deal, something that cannot be bought or sold through the brokerage. This is a high risk issue. It's not necessarily wrong for the manager to propose that you invest in a private placement, but it exposes you to a ton of risk, not only investment risk but fraud risk. What is that private placement worth? You'll have to trust your advisor. Was your advisor paid a kickback to get you to invest in the private placement? That's not a hypothetical concern; we had just such a case in my town. The investment advisor ended up going to jail, but that didn't help the investors much, aside from some psychological satisfaction. When your investment advisor puts you into listed stocks and bonds that you can get quotes on from any brokerage or Internet site, your fraud risk is dramatically lower than if you are investing in private deals.
The second challenge to third party custody is the hedge fund structure. In a hedge fund, your money is commingled with other clients' funds in what you might think of as a small mutual fund. But hedge funds lack the reporting requirements of mutual funds. As a result, your fraud risk is high. It might be worth it, but there's definitely risk.
Finally, don't let the risk of fraud keep you from making a decision. Your financial success depends on you getting invested. Sitting in cash while you try to make a decision is a disastrous strategy. If you are really, really afraid, consider using three different advisors. However, unless you have a lot of money, you'll pay more for three different advisors than if you gave all the business to just one.