A hedge fund collapse is always a possibility due to the tenuous nature of the vehicle so investors must be especially vigilant of hedge fund fraud.
Depending upon its investment strategy, each hedge fund has its own unique investment risk. Investors should fully understand the risk in investing in hedge funds and should conduct appropriate due diligence prior to investing.
There are various methodologies for performing due diligence, but basic investigations should include:
- Reviewing www.sec.gov for past regulatory actions against the fund manager;
- Reviewing state securities agencies Web Sites;
- Reviewing federal district, bankruptcy and appeals court records through www.uscourts.gov/courtlinks
- Locating and speaking with fund administrators and noting their independence;
- Ensuring that a reputable independent accounting firm performs an annual audit.
In addition, hiring a professional due diligence firm to perform a more thorough background check is a wise decision to help safeguard from hedge fund fraud.
While the SEC can take action against fraudulent funds, investors must remain vigilant for signs of misrepresentations and outright fraud. Commonly, fund advisors misrepresent their professional experience and the fund’s investment track record. Increasingly, the misrepresentation of risks, investment strategies and the amount of leverage used in risky transactions has been seen.
Ponzi schemes have also been used to lure investors to hedge funds, often with devastating results. In this scenario early investors are paid interest, which gives the scheme the aura of legitimacy. According to the SEC, some funds have sent fraudulent account statements in order to keep investors in the dark regarding the funds status. Often, by the time the scheme is uncovered, the entire fund has been depleted.
The Securities Exchange Commission and the Commodity Futures Trading Commission have identified several indicators of hedge fund fraud:
- Lack of trading independence – hedge fund managers trading through affiliated broker\dealers;
- Investor complaints – investors being unable to redeem their investments in a timely fashion;
- Audit issues – lack of audits by reputable independent accounting firms
- Litigation – civil suits and securities arbitrations against hedge funds filed by investors alleging fraud; Unusually strong performance claims – hedge fund performance claims are better than market average over a long period of time;
- Illiquid investments – investing in a commodity which is not easy to value (incentive to overvalue investment in order to earn a larger commission);
- Valuation issues – use of related parties to value illiquid investments or use of a non-independent fund administrator;
- Personal trading – hedge fund managers trading in their own accounts;
- Aggressive Bear Shorting – hedge funds take a short position in a stock (betting it will go down) and orchestrate efforts to disseminate unfounded or materially false negative information about the stock, eroding the price and allowing the perpetrators to profit on the short position.
Click here for an example of hedge fund fraud provided by the SEC.
If you have already invested in a hedge fund there are several steps you can take to monitor for hedge fund fraud:
- Thoroughly read and understand a fund’s prospectus and memorandums;
- Engage fund managers by asking questions and taking notes;
- Save all documentation;
- Consult an attorney before signing any investment commitment;
- Take special care about navigating redemption and litigation rights;
- Do not rely on a set static checklist – different funds can employ radically varying investment strategies, and must be judged individually;
- Look closely at the fund’s transparency, third party pricing, quality and control of people, and internal processes.
If you do suspect hedge fund fraud, you should contact a securities attorney immediately to best protect your assets.