| For thousands of years investment advisors have | | | | vehicle, how can an investor protect against these |
| been asking investors to give them money so | | | | frauds? Like any investment, the investor must |
| they could invest it for them. Even after Charles | | | | do due diligence before investing in a fund. The |
| Ponzi in the 1920's, investors have continued to | | | | investor should review the funds offering |
| give investment advisors money to invest. The | | | | materials, investment objectives, audited financial |
| mutual fund industry has been the largest vehicle, | | | | statements, background of investment advisors |
| but is highly regulated and has produced few | | | | and other documentation provided by the fund. |
| frauds. Unregulated investment schemes, such as | | | | He should verify the size of the portfolio with the |
| PONZI schemes and its brother, pyramid | | | | fund's custodian. He should check the background |
| schemes, have been the most prolific types of | | | | of the personnel of the investment advisor |
| investment fund frauds. Hedge funds could be the | | | | working on the fund. He should check for |
| next significant vehicle. Hedge funds have gained | | | | regulatory action against the investment advisor |
| in popularity to a staggering investment amount | | | | and its personnel. He should evaluate the ability of |
| of over $2 trillion, according to the SEC. Over | | | | the outside auditor. He should determine who |
| 2,400 investment advisors have registered 11,500 | | | | prepares the periodic financial statements |
| hedge funds with the SEC this year. | | | | provided investors and whether there is |
| So why would hedge funds produce the next | | | | third-party oversight. He should determine if the |
| really big fraud? According to the Association of | | | | fund has registered with the SEC. He should check |
| Certified Fraud Examiners and Financial Accounting | | | | with others in the industry that have knowledge |
| Standards Board, the environment for fraud | | | | about the fund. |
| includes three factors, "incentives/pressures, | | | | After the investment is made the investor's due |
| opportunities, and attitude/rationalization." The | | | | diligence should not stop. Many of the documented |
| hedge fund manager certainly has the pressure | | | | hedge fund frauds have not started in the |
| from his investors to produce results. He also has | | | | beginning of the fund, but after the investors |
| an unregulated environment to work in producing | | | | became comfortable. The investment advisors |
| the opportunity. Additionally the high risk/high | | | | continue to be pressured to produce results or |
| reward attitude of the manager makes him more | | | | lose their investors. The investor should continue |
| likely to take the risk of defrauding his investors. | | | | to review the reports sent to him by the fund. |
| A quick review of the SEC litigation releases in the | | | | He should verify the size of the portfolio with the |
| past year shows increased activity against hedge | | | | custodian on a periodic basis. He should watch for |
| funds, including: altering audited financial | | | | changes in auditors and other third parties. He |
| statements, concealing losses, creating a fictitious | | | | should be alert for any regulator action against the |
| auditor, insider trading, market timing (mutual | | | | fund or its advisors. He should not let the early |
| funds), misappropriation, misrepresentation to | | | | withdrawal penalties deter him from withdrawing |
| investors, non-disclosure to the SEC, and stock | | | | at the first sign of trouble. In most of the |
| manipulation. These frauds were not limited to | | | | documented cases, there is little left, after |
| small or offshore funds, but included funds with | | | | discovery of the fraud and the litigation to |
| hundreds of millions of dollars operating throughout | | | | recover from the fraudsters and third parties. |
| the US. Are these all of the frauds occurring? No, | | | | The answer is that some hedge funds are |
| but these are simply the ones which the SEC has | | | | defrauding their investors while they are not more |
| litigated against. No one knows in this unregulated | | | | closely regulated. With the increasing popularity |
| environment how many frauds are occurring | | | | and size of some of these unregulated funds, one |
| today. | | | | of these may be the next really big fraud. Don't |
| Since hedge funds are still a popular investment | | | | be the investor caught in it! |