Flagging potential fraudulent investment activity
| Pages | 882-901 |
| DOI | https://doi.org/10.1108/JFC-09-2015-0051 |
| Published date | 03 October 2016 |
| Date | 03 October 2016 |
| Author | Jeremy King,Gary Wayne van Vuuren |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial crime |
Flagging potential fraudulent
investment activity
Jeremy King
Department of Commerce, University of Cape Town, Cape Town,
South Africa, and
Gary Wayne van Vuuren
Department of Economics, North West University,
Potchefstroom, South Africa
Abstract
Purpose – This paper aims to investigate the use of the bias ratio as a possible early indicator of
nancial fraud – specically in the reporting of hedge fund returns. In the wake of the 2008-2009
nancial crisis, numerous hedge funds were liquidated and several cases of nancial fraud exposed.
Design/methodology/approach – Risk-adjusted return metrics such as the Sharpe ratio and Value
at Risk were used to raise suspicion for fraud. These metrics, however, assume distributional normality
and thus have had limited success with hedge fund returns (a characteristic of which is highly skewed,
non-normal return distributions).
Findings – Results indicate that potential fraud would have been detected in the early stages of the
scheme’s life. Having demonstrated the credibility of the bias ratio, it was then applied to several indices
and (anonymous) South African hedge funds. The results were used to demonstrate the ratio’s scope
and robustness and draw attention to other metrics which could be used in conjunction with it. Results
from these multiple sources could be used to justify further investigation.
Research limitations/implications – The traditional metrics for performance evaluation (such as
the Sharpe ratio), assume distributional normality and thus have had limited success with hedge fund
returns (a characteristic of which is highly skewed, non-normal return distributions). The bias ratio,
which does not rely on normally distributed returns, was applied to a known fraud case (Madoff’s Ponzi
scheme).
Practical implications – The effectiveness of the bias ratio in demonstrating potential suspicious
nancial activity has been demonstrated.
Originality/value – The nancial market has come under heightened scrutiny in the past decade
(2005 – 2015) as a result of the fragile and uncertain economic milieu that still (2015) persists. Numerous
risk and return measures have been used to evaluate hedge funds’ risk-adjusted performance, but many
fail to account for non-normal return distributions exhibited by hedge funds. The bias ratio, however,
has been demonstrated to effectively ag potentially fraudulent funds.
Keywords Hedge funds, Bias ratio, Omega ratio, Sharpe ratio
Paper type Research paper
1. Introduction
Hedge funds may be distinguished from collective investment schemes (CIS) by the
investment strategies they use. These include, in addition to conventional long-only
strategies, gearing, short selling and script lending. Such strategies result in different
risk and return drivers (AIMA, 2009). The double-digit returns generally yielded by the
hedge fund industry over the past two decades (1990s and 2000s), coupled with the
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFC
23,4
882
Journalof Financial Crime
Vol.23 No. 4, 2016
pp.882-901
©Emerald Group Publishing Limited
1359-0790
DOI 10.1108/JFC-09-2015-0051
perception that funds, are uncorrelated with traditional investments and should
therefore provide stability during tough economic milieus, have attracted considerable
assets from other investment arenas (Getmansky et al., 2004). This perceived stability
during tough economic times coupled with the consistently earned stellar returns during
positive market conditions, has traditionally resulted in capital ow from wealthy
individual and institutional investors, seeking capital preservation and superior
returns. This large, steady capital ow into hedge funds has grown the global industry
substantially over the past two decades to $2tn (Barclay Hedge, 2014).
Financial events in recent economic history have heightened scrutiny with regard to
the nancial industry as a whole, and in particular the hedge fund industry. In 1997, the
Asian nancial crisis and failure of long-term capital management together with the
2008-2009 global nancial crisis which resulted in numerous hedge fund liquidations
and exposed some of history’s largest nancial frauds, has raised much negative
publicity and regulatory concern. As a result, the management and understanding of
risk with regard to the industry has become important to management, and to both
potential – and current – investors.
Investors favour hedge funds with high risk-adjusted performance metrics, in
particular the Sharpe ratio (Botha, 2007), as well as funds that consistently produce
frequent, positive returns (Bollen and Pool, 2008). As management fees are partially
based on assets under management (AUM), managers have an implicit incentive to
generate Sharpe ratios that are superior to their competitors’ ratios. This can lead to
managers “smoothing returns” around zero resulting in an increased frequency of
positive returns and reduced volatility – both of which ultimately produce higher Sharpe
ratios (Bollen and Pool, 2008).
The Sharpe ratio, although used extensively in the industry, assumes that
returns are normally distributed, an assumption inapplicable to hedge funds
because of complex investment strategies and the trading of illiquid and
hard-to-value assets (Getmansky et al., 2004). Excessive, persistently high Sharpe
ratios may be used to ag potential fraud (van Vuuren, 2009). Fragile economic
milieus provide environments in which certain metrics may ag fraudulent or
suspicious activity early in a fund’s life, before nancial damage sets in. These
metrics are highly benecial to all stakeholders.
The bias ratio (which does not rely on distributional normality for returns) is one
such metric (Abdulali et al., 2009) having been applied retrospectively to funds and
found to reliably ag those that have been – or are – potentially fraudulent.
This paper applies the bias ratio to Faireld Sentry Ltd. (FFS) (the well-known
Ponzi scheme administered by Bernie Madoff) and compares the ratio to a proxy for
a non-fraudulent fund, the S&P500, as conducted by various researchers (Abdulali
et al., 2009;van Dyk et al., 2014). This paper also applies the metric (and others) to
several South African hedge funds.
The remainder of this paper is structured as follows: Section 2 examines the
literature governing the hedge fund industry, risk-adjusted performance metrics
used in the industry and problems associated with these measures. Section 3 details
the data and methodology used for the analysis on the South African hedge funds,
and Section 4 presents the results and a discussion of salient observations. Section 5
concludes.
883
Fraudulent
investment
activity
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