Academics dabble in vexillology to better predict hedge fund fraud

(C) YuGovernment oversight, such as the requirement to register a hedge fund with the SEC, has long been touted as one of the best ways to increase transparency and expose the inner workings of a hedge fund to the harsh light of day.  Although SEC registration remains voluntary (for the time being), the fact that half of all hedge funds have registered is surely a good thing, right?  As regular readers know, previous regulatory transgressions (as reported on the firm’s Form ADV) are a modest predictor of future problems (see previous post).

But what if the only funds that register are the ones with nothing to hide?  That’s what Nicolas Bollen of Vanderbilt University and Veronika Pool of Indiana University wondered.  They hypothesized that you may be able to predict future regulatory or legal transgressions based on something far more ubiquitous than Form ADV’s:  performance figures.  In their March 2010 paper “Predicting Hedge Fund Fraud with Performance Flags,” the vexillologist duo test this hypothesis.

But exactly what kind of “flags” are we talking about?  Bernie Madoff, after all, succeeded for so long precisely because he flew just below (nearly) everyone’s radar screen, posting individual monthly numbers that were never anything to write home about.  In addition to performance indicators, Bollen and Pool’s collection includes a variety of less obvious flags such as the following “suspicious patterns in returns”:

  1. a discontinuity in the distribution of hedge fund returns,
  2. low correlation between hedge fund returns and the returns of systematic risk factors,
  3. serial correlation in hedge fund returns,
  4. conditional serial correlation in hedge fund returns, and,
  5. a family of six data quality indicators (e.g. the percentage of negative returns, the percentage of repeat returns, and the number of returns exactly equal to zero).

Distributional Discontinuity

Regular readers may recall Bollen and Pool’s 2007 paper showing that there is an odd dearth of hedge funds that report monthly returns that are just below zero (the assumption being that managers somehow goose returns just to get rid of that pesky minus sign).

They apply the same logic to “non-problem funds” (defined by ADV-reported regulatory transgressions) and those with previous ADV-reported trading violations…

As you can see, funds with a history of regulatory infractions also tend to miraculously avoid having small negative losses.  Amazing skill, eh?

Low Correlation

Although having a low correlation to any passive index is considered the raison d’etre of the hedge fund industry, Bollen and Pool point out the reality that,

“…a manager who reports a random positive return every month will artificially generate a correlation between the fund’s returns and any other time series very close to zero…”

Serial Correlation (a.k.a. “return smoothing”)

The dearth of slightly negative results among regulatory transgressors seems to suggest some kind of “extra-investment” influence on fund returns.  Serial correlation doesn’t necessarily mean that a manager is cooking the books.  But it’s conceivable that they may decide to sell a security at a market price that differs from its mark to model price only when that market price is higher.  This “return reserve” (our term) is also borne out by Bollen and Pool’s analysis of serial correlation.

Whacky Performance Data

You’d thing that anyone making up their own performance data would think to avoiding picking the same numbers, right?  Not so.  Bollen and Pool actually find that funds with a history of reporting transgressions actually have a higher probability of reporting the same returns in separate months.  They also have a higher probability of producing identical returns in separate months.  (Note to fraudsters:  use Excel’s random number generator next time!)

“Reporting Violations” vs. “Trading Violations”

None of this means that a fund with a regulatory infraction is necessarily destined to be fraudulent.  Securities regulators around the world hand out fines on a regular basis to some of the biggest and highest quality firms around.  But usually those violations are trading related.  Bollen and Pool find that their performance flags are more likely to be associated with reporting violations than trading violations. This makes sense we suppose.  You can always fire a rough trader, but the propensity to misreport is directly associated with the culture of the management company itself.

More than just a vexillologistic exercise, Bollen and Pool say their approach still has “important regulatory implications.”

“Our results provide support for the SEC’s efforts to target funds for examination using risk-based screens, since funds which trigger performance flags are much more likely to ultimately be charged with legal or regulatory violations…anti-fraud provisions of the securities statutes are a stronger deterrent to unlawful behavior when the probability of getting caught is higher…”

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