Penny Cagan, Managing Director and Head of Content Group, Algorithmics, said: âThe size and breadth of recently reported hedge fund fraud events illustrates the imperative necessity of undertaking proper due diligence and of framing the right questions when analyzing vehicles for investment funds. Service providers to the Madoff feeder funds, such as custodians, are becoming targets of lawsuits by investors who are seeking to be made whole. This means that due diligence is equally important for not just investors, but also custodians, prime brokers, and fund administrators.â
When asked if recent activity equates to a large increase in recent reports of hedge fund fraud events, Penny Cagan added that, âon the contrary, many of these events have been ongoing for years and in some cases, decades. They are being discovered now as a result of the turmoil in the financial markets and the associated increase in redemption requests. Fraudsters cannot hide their misdeeds when investors want their money back.â
The following provides a sampling of just ten of the most important questions that should be asked by anyone who has investment exposure to a hedge fund; a list of twenty-two key questions have been developed from the hedge fund frauds and blow-ups in the Algo FIRST database:
1. What is the experience level of senior traders and management?
2. What is the quality of stress testing and risk scenarios and do they include the interplay of different types of risk and market events? Do the stress tests account for an unraveling of different types of securities by major market players at the same time?
3. Has investment drift occurred? Do actual investment strategies match what is reported in fund prospectuses?
4. What is the operational risk culture within a fund and does a star culture exist? Who are the stars? Are traders that push the boundaries tolerated or heralded?
5. Is there a concentration in certain securities or strategies and is overconcentration in a certain position present?
6. What is the quality of the fundâs market practices and is there a potential for conflict of interest and fiduciary breaches?
7. What exchanges does the hedge fund trade on and are they regulated or unregulated exchanges?
8. Are the staffing levels appropriate to support the infrastructure of the fund? Do they keep abreast of growth in assets?
9. Has there been a dramatic change in assets under management and/or level of redemptions during the past year?
10. What is the quality of back office operations and support and trade processing, execution, confirmation, and the percentage of failed trades?
Hedge fund blow-ups comprise a sub-section of 8,500 carefully researched and analyzed case studies in the Algo FIRST database.