Five signs that a hedge fund is a fraud

Nick BollenLong before the world heard of Bernie Madoff  -- or his $65 billion Ponzi scheme -- an independent financial investigator named Harry Markopolos spotted a series of irregularities in the convicted felon’s hedge fund suggesting it was generating impossibly high returns.

Photo (right): Nicolas P.B. (Nick) Bollen, E. Bronson Ingram Professor in Finance

But when Markopolos presented his 21-page analysis about problems with Madoff’s investments to the Securities and Exchange Commission in 2005, he was startled to find that the New York branch chief didn’t express “even the slightest interest in asking me questions.” Two years later, the agency closed the investigation without filing a single claim.

After Madoff was finally exposed, Markopolos blasted the agency in Congressional testimony for having too few staff members “with relevant industry experience and professional credentials to find fraud even when a multi-billion dollar case is handed to them on a silver platter."

Now, as part of a sweeping set of new financial reforms signed into law in July 2010, the SEC has been granted expanded powers to monitor potentially risky investments like Madoff’s fraudulent hedge fund. For example, funds with more than $100 million must now register with the SEC, giving more data to the oversight agency.

Those measures will likely add to efforts already underway within the agency to perform relatively simple screens similar to the type Markopolos used to identify Madoff’s troubled investments.

According to new research from Nicolas Bollen, professor of finance at Vanderbilt University’s Owen Graduate School of Management, running a set of preliminary, low-cost screens has proven effective in flagging hedge funds that may warrant deeper investigation.

“The approach we’re validating for hedge fund monitoring is in some ways similar to the one used by the IRS to determine which tax returns to audit,” Bollen says. “By statistically parsing through funds and identifying ‘red flags,’ we demonstrate financial regulation can work without being prohibitively expensive.”

In a recent paper, “Predicting Hedge Fund Fraud with Performance Flags,” Bollen and co-author Veronika Pool of Indiana University identified five effective indicators for monitoring hedge fund fraud that include:

1.    A kink in the fund’s distribution of returns at zero
A statistical test will show a lack of smoothness -- a kink -- in a hedge fund’s distribution of reported returns at zero. This may indicate an effort to avoid reporting a loss by inflating returns in one month, then later reversing the overstatements. When calculating returns on a bimonthly basis, the study found that this kink disappears.

2.    A low correlation with other assets
Hedge fund returns should be correlated with a set of investment “style factors,” which researchers developed to mimic well-known hedge fund trading strategies. A low degree of correlation could be the result of a hedge fund actually making good on its promise to deliver unique returns. However, Bollen argues that if no reliable correlation exists, it is likely that the hedge fund returns are distorted, perhaps in an effort to mask risk, or, as in the case of Madoff, because they were being fabricated.

3.    Artificially smooth returns

Returns that show a low level of volatility and a positive serial correlation could be the result of hedge fund managers purposely smoothing returns by reporting moving averages. Research has shown that moving averages feature lower volatility than raw observations, and will possess serial correlation even when raw observations have none.

4.    Losses being reported differently than gains
When the serial correlation is conditional on a particular variable, it may point to a hedge fund manager’s desire to smooth losses by delaying reports of poor performance, and to fully report gains in hopes of winning investor capital.

5.    Poor data quality
Portfolios can be analyzed for “man-made” data patterns that include characteristics such as too many returns exactly equal to zero, too few unique returns, too long a string of identical returns and an extremely low percentage of negative returns. On the last point, the authors say there would naturally be very few reported losses if returns were being made-up, such as in a Ponzi scheme.

Bollen and Pool used these screens to compare a pool of 8,770 existing and defunct hedge funds between 1994 and 2008. A sample of 195 “problem” funds that had been the subject of SEC enforcement actions or investor lawsuits was identified in the group. The study showed that funds charged with reporting violations triggered the performance flags at a substantially higher rate than other funds.

Strikingly, the authors assert that some of the funds used in the study that were identified as not having violations may in fact pose an ongoing fraud risk. “Our performance flags may be indicating that some of the non-problem funds are in fact at higher risk of fraud but have not yet been charged with any violations,” Bollen and Pool write.

Bollen noted that the critical role of databases in identifying potential fraud underscores the importance of requiring hedge funds to disclose key information. This is currently a voluntary procedure, even under the new financial reform law.  

“Mandatory reporting can only serve to aid regulatory agencies working to root out fraud,” Bollen says. “The increased data would also promote additional research that could protect investors from future schemes.”

This performance-flag approach could be applied to deter fraud in a wide range of investments, according to Bollen.

“The flags might be different but the basic strategy is the same,” he says. “The information we are providing can also benefit investment advisers by making them aware that pre-screening can be a very effective way to protect client portfolios. They will have additional means to identify potential investments that should require especially careful due diligence.”

Published Nov 1, 2010 in Vanderbilt Business Intelligence
Copyright 2010 Vanderbilt Owen Graduate School of Management