What Is Hedge Fund Fraud?

Terry Masters

Hedge fund fraud is the intentional misrepresentation of some part of an investment opportunity in a hedge fund by the managers of the fund in order to entice investors to commit money. This type of investment is not as strictly regulated as ordinary mutual funds, and only certain investors are allowed to purchase hedge funds. Fraud, as a result, is not necessarily any more frequent than in the other areas of the financial industry, but when it does occur it tends to involve an ongoing scheme, large sums of money, and questions about the lack of regulatory oversight.

Hedge fund fraud is the intentional misrepresentation of some part of an investment opportunity in a hedge fund by the managers of the fund.
Hedge fund fraud is the intentional misrepresentation of some part of an investment opportunity in a hedge fund by the managers of the fund.

Investment funds are either funds that are available for purchase by the public or those that are not. A hedge fund is an investment vehicle that develops a portfolio designed to “hedge its bets”, or strategically invest in diverse, even contradictory, assets so the performance of the fund as a whole is protected against downturns in the market. The private nature of the fund means that by law only certain types of investors are eligible to buy in. Major institutions, pension funds, university endowments, charitable foundations, and individual investors with personal wealth over a certain threshold are typical hedge fund investors.

Regulatory controls and disclosure requirements are much less strict than what are in place for other investment vehicles that are sold to the public. Hedge fund investors are required to conduct their own due diligence regarding the legitimacy of a fund and to manage their investment prudently over time. The fund managers have a wide berth and little oversight when presenting and managing funds.

Hedge fund fraud is perpetrated by the managers of the fund who make material misrepresentations about the fund in order to entice investors. A popular example of this type of fraud is a ponzi scheme. In a ponzi scheme, a fund manager pays out returns on investments from the income generated by the deposits of new investors rather than through the income made off of profitable holdings and trades. Once the pool of new investments runs dry or if current investors decide to withdraw their money in too large a group, the fund can no longer maintain its rate of payout and collapses in on itself.

Ponzi schemes involving hedge fund fraud have been the vehicle of choice for some of the most damaging investment frauds of all time, bilking investors out of billions of dollars. The requirement that investors have to be “qualified” to invest lends a certain aura of exclusivity to certain funds that indemnify fund managers from the type of scrutiny that might be faced in an open opportunity investment. Hedge fund fraud is statistically no more prevalent than fraud in other areas of the financial industry, but any instance of fraud has a significant impact because of the type of investors involved and the size of the assets.

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