More than three quarters of all hedge fund defaults are due to fraud or misrepresentation, according to a study by economists at the EDHEC business school in Nice.In a study of 109 defaults (defined as losses large enough to stop the fund manager investing), 78% involved fraud or failure to disclose the true state of the fund. The study also found that 54% were caused by fraud, 17% by undisclosed financial issues and 6% by undisclosed operational errors; the remaining defaults were the result of disclosed operational (6%) or financial problems (16%).
US funds were more likely to suffer from fraud. The report's authors, Corentin Christory, Stephane Daul and Jean-Rene Giraud, suggest this could be because more US funds keep the responsibility for calculating net asset value in-house rather than outsourcing it to an independent administrator. Small funds are also more likely to suffer from fraud.
Unsurprisingly, operational problems are more likely to affect funds investing in complex financial instruments, which include more opportunities for error.
Diversifying can reduce the expected loss due to fraud, but can do less to reduce the risk of operational error, the authors suggest.
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