the new approach
Today’s Wall Street Journal tells about current SEC efforts to scan the hedge fund universe in search of potential civil fraud. The idea is to use computer analysis to identify hedge funds whose results are too good to be true–where the operators rarely, if ever, have a down month, or where aggregate results are sensationally good. This new direction apparently comes as a result of the agency’s failure to detect the gigantic Ponzi scheme that Bernie Madoff ran for many years–despite being supplied continuous evidence of the fraud by investigator Harry Markopolos.
Markopolos, a financial analyst, was asked by his employers to “reverse engineer” Madoff’s returns and create a duplicate it could market to clients. A quick look at the numbers was enough for Markopolos to suspect fraud. It took him less than a day to develop conclusive proof, which he then tried in vain to present to the SEC for close to a decade.
The new SEC interest in hedge funds appears to mimic the Markopolos methods. The agency is also extending its scrutiny to mutual funds and private equity.
it’s about time
For years, academic studies have concluded that the returns hedge funds report to the public are at best implausible, and most likely false.
My favorite is one led by NYU professor Stephen Brown. He analyzed investigations done by a hedge fund due diligence firm, HedgeFundDueDiligence.com, which was hired by potential institutional customers to check out new managers. It turns out that about a fifth of the hedge funds misled HFDD.com, despite the fact they knew their assertions would be checked. It also turns out that customers generally hired the dishonest hedge fund managers, despite the due diligence warnings. Go figure.
The biggest reasons for falsifying returns, in my view, is that reporting is voluntary and that the databases which collect the numbers make no attempt to check the figures.
The WSJ article cites the case of the now-defunct ThinkStrategy Capital Management. TSCM reported a return of +4.6% for 2008 in its Capital Fund-A, a year in which the fund actually lost 90%. Chetan Kapur, who ran TSCM, also reportedly inflated his assets under management in reports to shareholders and wrote about non-existent team of analysts supporting him. Kapur also continued to manufacture and report performance numbers for Capital Fund-A, even after the fund was shut down.
The article says there are lots more where TSCM came from.
I believe it.