PDF Reeling from accusations of incompetence for its failure to detect the $17.3 billion Madoff Ponzi scheme, the U.S. Securities and Exchange Commission (SEC) has unveiled a new analytical tool for uncovering fraudulent investment management operations. Essentially, the SEC has begun to evaluate historical reported returns to determine if they are in the realm of possibility. Such an analysis (as was done by Harry Markopolos1) would have revealed Madoff as an extreme outlier and thus worthy of further investigation. So far, the SEC has identifed about 100 suspicious hedge funds and has filed four civil-fraud lawsuits based on the results of the “aberrational performance initiative.” One of these funds reported annual returns of 25% by taking liberties in the valuation of its dodgy assets such as Nigerian warrants. As part of this initiative, the SEC has promised to take a hard look at private equity funds which report their returns based on their own proprietary valuations of their holdings.
Perhaps the SEC’s most noteworthy catch is Chetan Kapur of ThinkStrategy Capital Management LLP. In 2008, this hedge fund reported a 4.6% return (its sixth consecutive positive return) while the average hedge fund lost 19%. Of course, the 4.6% return was false, as the fund actually lost 90% in 2008. Mr. Kapur’s shenanigans also included gross exaggeration of assets under management and the invention of a fictitious management team. Since the SEC brings only civil enforcement actions, Mr. Kapur currently faces only the prospect of fines and banishment from the financial services industry.
As expected, a few active managers have complained that they might be singled out for scrutiny purely as a consequence of their success. SEC enforcement chief Robert Khuzami suggested that any fund that consistently beat market indexes by a margin of 3% or higher would receive special attention. Of course, if the fund legitimately achieved those returns, then there should be no cause for worry. In an independent study2 of 614 actively managed long-only domestic equity mutual funds for the ten-year period ending 8/31/2011, Index Funds Advisors found not one that met (or even came close to) the consistent 3% criteria outlined by Mr. Khuzami.
IFA wishes the SEC continued success in this long overdue and highly important initiative that will go a long way towards protecting investors from the sharks of Wall Street.
1“No One Would Listen: A True Financial Thriller.” Hoboken, NJ: John Wiley & Sons. March 2010
