HEDGE FUND FRAUD

Hedge fund fraud is a type of investment fraud and is any act of financial misconduct committed by or for the account of a hedge fund. To understand its many forms, it helps to take a step back and explain what hedge funds are and how they function.

“Hedge funds” are investment structures in which investors pool their assets, and a manager invests those assets on the investors’ behalf for a fee. They were originally conceived as niche investing vehicles that helped wealthy, sophisticated investors “hedge” their investment portfolios against market movements by engaging in trading strategies that did not depend on which direction the markets went. Some early hedge funds gained reputations for delivering outsized returns to investors. Many more became notorious for reaping their managers extraordinary fortunes despite delivering only mediocre returns for investors.

Today, the term “hedge fund” has a looser and broader meaning than it once did. Most often, it’s used to describe any private, pooled-asset investment fund with a limited number of investors, a fee structure that pays management based on the percentage of funds-under-management plus a percentage of investment gains, and restrictive rules about when and how investors can withdraw their money. Hedge funds are lightly regulated and often use borrowed money (“leverage”) in pursuit of large returns.

Hedge funds attract investors largely based on the reputation of their managers and the secret sauce of their investment strategies. Investors put their money into hedge funds in hopes the manager’s investing magic will deliver market-beating returns. Like an exclusive club, the investing allure of a hedge fund relies heavily on:

• the fund only being open to people who meet certain financial or other criteria; and
• the difficulty outsiders have seeing what goes on inside (in terms of investment strategies).

Initially, hedge funds ensured their exclusivity by requiring large minimum investment amounts affordable only to the world’s wealthiest people. Although restrictions on who can invest in hedge funds today remain common, some investment vehicles calling themselves “hedge funds” have investment thresholds that put investing in them within the reach of a much broader slice of the investing public. As the number of hedge funds has grown and the investor base has widened, funds’ profit margins have tightened and competition has increased, creating a temptation for fund managers to engage in wrongdoing to stay in business.

In contrast to funds becoming more accessible to investors, the relative secrecy with which hedge funds operate endures. Not only do hedge funds rarely have to report their performance to the public, but even investors may have access to limited information about the fund’s investment strategies and returns under the terms of the fund’s governing agreements. This secrecy is necessary for hedge funds to operate. After all, funds can’t make money in a highly competitive investment environment without keeping their trading positions and plans mostly hidden from public view. However, a fund’s insistence on secrecy and on the supposed investing genius of its managers can also facilitate fraud on investors.