How investors can identify fraudulent funds

Eugeniu Chirau

Oct 30, 2024

Over the years of analyzing various investment products, we have developed several heuristic rules that can help anyone investing in funds significantly increase their chances of avoiding contact with fraudsters and being able to identify them immediately.

• High returns, low risk, and high liquidity cannot be combined in one product. In macroeconomics, there is the rule of the 'impossible trinity,' which states that it is impossible to simultaneously achieve three goals: a fixed exchange rate, free capital movement, and an independent monetary policy. Experience shows that a similar trilemma exists in investment products: of high returns, low risk, and high liquidity, only two can be chosen. If you are promised all three, it is most likely fraud — or one of the conditions is not being met. The best products can consistently meet two of these conditions, most — only one.
• Even a clean biography of a manager does not guarantee complete honesty, and a tarnished one almost always leads to problems. The presence of criminal cases in a biography means that it will likely happen again in the future. In analyzing one fund, we discovered traces of the manager's fraud based on court materials describing his actions in 1999. The next episode of fraud organized by this person became public in 2019. This is one of those cases where the product's results were truthful enough for new fraud to be uncovered 20 years later, after the scheme had existed for almost a decade and assets reached half a billion dollars. A clean biography also does not reduce the risk of dishonest behavior. In this case, only a pragmatic analysis of the balance of benefits and losses from dishonest behavior can help. One of the controversial but important conclusions of such an analysis is formulated as follows: the older the management team and the higher the concentration of business share in the hands of such individuals, the greater the motivation for their dishonest behavior or taking excessive risks.
• The best products focus on attracting capital from large professional investors, not retail ones. For management companies, investments are a business. With a good product, it is most effective to build relationships with investors who can invest large sums. If a product primarily targets small investors, it indicates that it failed to get money from other parties. Very often, due to the 'mass' nature of such a business model, it is organized through intermediaries willing to sell products of any quality for a good commission. Both are not necessarily 'red flags,' but experience shows that both the target audience and the quality of intermediaries differ significantly between good and frankly bad or dishonest products. After communicating with many dozens or hundreds of funds, we see that the line between the first and the last becomes more tangible. Moreover, the best strategies are usually limited in the amount of money they can manage without sacrificing product quality and investor returns. There may be a queue for the opportunity to invest in such products, and they certainly will not impose themselves.
• Good auditors and administrators are great, but even they do not guarantee protection from sophisticated fraud. Both can only detect direct attempts to withdraw money or other dishonest actions, which is often sufficient for strategies that trade only market instruments. However, when strategies in low-liquidity or non-traded instruments are implemented in a product, it is difficult to detect fraud even for auditors or administrators. Even if they are detected, neither party is interested in investigating, and the case will likely be limited to changing the service provider. Fraudsters often use the notoriety of service providers to create a false sense of product reliability. The problem is that the notoriety of providers does not provide additional protection. And not always the presence of 'second or third league' providers means that managers are dishonest. We have encountered honest teams working with little-known providers and dishonest ones working with well-known ones. Ultimately, relevant for protection against fraudsters will be only the team's background, understanding of the product strategy, transparency of instruments, and reliability of their value assessments, as well as the absence of frequent provider changes or systematic deterioration of their quality.
• Exotic products are associated with exotic risks, including fraud. This is especially common in niche private lending, where traditional bank financing is either absent or banks have left. Experience shows that this is not so much due to Basel regulatory requirements (a common argument of managers of such strategies) as to the fact that banks often lost money in these niches. This is usually due to poor credit quality, difficulty in assessing collateral, imperfect laws, and problems with enforcing creditors' rights to collateral or frequent episodes of fraud. Fund managers in such niches, unlike banks, which cover losses from shareholders' pockets, act only as agents, creating a conflict of interest between managers and investors. All risks are borne by investors, who are also the shareholders of this investment product. At best, this exacerbates problems — managers, in pursuit of commissions, are willing to distribute capital even to those whom a bank would refuse, as well as take out loans for this. Moreover, unlike investments in market instruments, in the non-public sector, there is a complete lack of an information transmission channel that would balance the asset price and such information, reducing the risk of moral hazard. The opacity of such products deprives investors of the opportunity to reliably know what is happening with their capital and to receive a higher expected return on new investments if the manager increases risk. In the worst case, the risk of collusion between managers and those receiving funds from investors (overseers and supervised) may materialize, and then the game is played not only for commission but also for investors' capital.
• Having one's capital in the fund does not guarantee that the interests of managers and investors have become closer. Firstly, the ratio of how much managers earn from the product and how much money they hold in it is more important. If this ratio favors earnings, then there can be no talk of aligning the interests of the parties. Also, managers always have more complete information about what is happening in the fund and can quickly withdraw their money from the product if problems are expected. As a result, the mere fact of having managers' money in the fund is less important than its relative size and whether the funds will remain in the fund in case of problems. At the same time, we noticed that too large a share of managers' money in the fund can also be a problem. In this case, there is a higher chance that managers will act irrationally, fearing to take a sufficient level of risk or untimely fixing losses due to fear of losing too large a portion of their funds. Ultimately, the optimal share of managers' capital in the fund is somewhere in the middle: not too little, compared to how much they earn from commissions, but not too much, compared to the share this product would occupy in its portfolio if it were managed by another team.
• Superficial description of the strategy in materials or excessive verbosity without disclosing the principles of the product and team should raise concerns. Sometimes the realization that you are dealing with a potentially fraudulent product arises immediately after viewing its presentation. It either lacks clear information about the strategy, portfolio, and principles of operation, or it is presented in such a way that an experienced investor, after analyzing the material, has no understanding of what exactly the managers are doing and how they manage to show the declared results. When this feeling persists after communicating with the managers, then you are most likely dealing with fraudsters, not an inept attempt to describe the product in written materials. It is worth noting that for funds with a large number of different quantitative strategies, this logic is only partially applicable. The fact is that even good managers often cannot disclose all the details of the strategy or disclose them in a way that would be completely understandable to an external investor. In such cases, the focus should be more on why such a strategy works in principle, what market inefficiencies it exploits, and why algorithmic competition has not led to the disappearance of such a niche for profit. Good quantitative strategies are usually based on some significant competitive advantages of the managers, which can be expressed in the team's competencies, access to alternative and less efficient markets, and the ability of the strategy to outperform competitors operating in the same field but less efficiently.

• Awards cannot always be considered an objective assessment of products. Awards may be given for formally meeting a number of criteria, completely ignoring reliability or other factors that do not affect the rating. Also, I am sure that many of them can be obtained not only for results but also for a monetary contribution. This does not mean that all awards are bad, but only that many of them have no relation to the quality of the product, and most of those issuing such awards take the honesty of managers as a basic assumption. As a result, awards are relevant only for products regarding the honesty of managers of which there are no doubts. This logic is not applicable in the opposite direction.
• Historical returns not confirmed by reliable audits have zero value. As in the Crawford case, a fabricated historical result is the best selling tool for dishonest managers. It is difficult to counter numbers with logical reasoning, and it is practically impossible to independently verify the authenticity of the results themselves. In this case, one has to rely on documents, reputation, and common sense. Audited annual financial statements are usually a good document for verifying returns, but all caveats from the audit section should be considered. If management was conducted on separate accounts, it is impossible to verify the authenticity of the results, and one has to rely on the honesty of managers and the authenticity of audit documents if any exist. Often managers may show the returns of only one account, not all accounts under management, which may distort the actual performance of their management. Back-tests, as a separate type of 'historical results,' should also either be ignored or accepted as the best option of what could have happened with the strategy historically. The first option is preferable.

Why This Matters

Private investors are more likely than professionals to risk not identifying a fraudulent fund. But there are no universal tips. Many criteria of suspicion cannot be considered as unequivocal 'red flags,' so they should be viewed in conjunction with other factors.