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A screen for fraudulent return smoothing in the hedge fund industry

The hedge fund industry has experienced a recent surge in popularity, with the number of funds and assets under management increasing at a much faster rate than in the mutual fund industry. The growth has generated a corresponding increase in aggregate managerial income. Incentive contracts are highly lucrative, usually including a guaranteed management fee between 1% and 2% of fund assets and a performance fee between 15% and 20% of fund profits.

Moderately successful managers can quickly become extremely wealthy, which explains a flight of talent from mutual funds and investment banks' proprietary trading departments.1 Critics in the popular press argue that demand for hedge funds has also contributed to increased instances of fraud, which are usually discovered ex post given the historically low transparency of the industry.

As described by the SEC (2003), "safe harbor" exemptions in the 1933 Securities Act, the 1940 Investment Company Act, and the 1940 Investment Advisers Act allow hedge funds to avoid substantial disclosure and record-keeping requirements. The SEC (2005) suggests that some managers are abusing their autonomy, citing as evidence 51 hedge fund fraud enforcement cases in the past five years.

In light of the tremendous growth of the hedge fund industry, the opacity with which hedge funds operate, and the resulting potential for fraud, the SEC recently adopted Rule 203(b)(3)-2 under the Investment Advisers Act to eliminate the private adviser exemption. As a result, most U.S. hedge fund managers will be required to register as investment advisers by 1 February 2006.

A screen for fraudulent return smoothing in the hedge fund industry