In a study examining the effectiveness of  five known “red flags,” Vanderbilt Owen Graduate School of Management professor Nicolas Bollen says he’s already picked out 195 possibly fraudulent hedge funds that haven’t yet been charged with violations.

Regulators are likely to use such “red flag” statistical screens to monitor hedge funds and identify cheaters early. The first step took place last week, on Friday, when the commission approved a preliminary rule requiring most hedge-fund managers, who currently operate with limited supervision, to register with the agency.  The agency has proposed requiring hedge funds and private-equity funds to submit to inspections and new disclosure requirements, aiming to expand oversight as required by the Dodd-Frank law.

The same concept—using statistical screens—could help investment advisors protect client portfolios, he said.   “A fund of fund manager or investment manager at an endowment or pension fund could use screens to identify funds which require extra diligence,” he said.  “The flags might be different but the basic strategy is the same,” he said.

The Securities and Exchange Commission, whistleblower Harry Markopolos, who alerted authorities to irregularities with Madoff’s investments as early as 2000 and the IRS all use statistical screens to pinpoint oddities.

Bollen used five tests.  One looked for evidence that a fund was avoiding reports of losses by inflating returns in one month, then reversing the overstatement the next. He also looked for delays in reporting losses, while reporting gains promptly.

Hedge funds promise unique returns. However, it’s a red flag if their performance is consistently different than that of a set of investment style factors mimicking standard trading strategies. The fund could be masking risk or making up their returns, as Madoff did.

A third red flag is an unusually smooth return. Low volatility could indicate that a fund manager is reporting moving averages.

Another screen would be signs of manmade data, such as a string of identical returns.

The more common such screens become, the more likely it is that funds would take steps to “pass” the test. Would they still be useful?  Bollen says, Yes. He believes the screens could lead to more “transparent" and “accurate valuation” of all portfolios.



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