The Securities and Exchange Commission (SEC) has recently unleashed a powerful new screening tool, Aberrational Performance Inquiry (API), to identify possible fraudulent valuations and misreported returns by hedge fund managers reporting above benchmark returns. Axiom Valuation’s AIRAS capability can protect hedge funds from a possible SEC API by demonstrating through a quantitatively robust and empirically defensible report that the fund’s self-reported returns match the fund’s strategies.
Last week’s SEC announcement of enforcement actions against three hedge funds and six individuals for misconduct including improper use of fund assets, fraudulent valuations, and misrepresenting fund returns, demonstrated a ground-breaking shift in the operating environment for hedge funds.
These are the first actions brought by the SEC using their new API capability, which utilises proprietary risk analytics to test hedge fund’s self-reported returns against the fund’s investment strategy or other benchmarks. For the first time, the SEC has an analytical and information advantage over the hedge funds it regulates. AIRAS returns the advantage to hedge funds that are accurately reporting their returns.
The SEC is casting a wide net across all hedge funds that are reporting performance of greater than three per cent above market indexes, according to testimony by Robert Khuzami, Director of the Division of Enforcement for the SEC in March, 2011. This means that most successful hedge funds will be targeted for at least some degree of further scrutiny by the SEC’s API process. This scrutiny cannot be good news for hedge funds in terms of management time, legal costs, and reputational risk. In essence, these successful hedge funds are guilty until proven innocent.
Fortunately, Axiom Valuation has developed AIRAS, the only hedge fund return authentication capability, that for the last three years has been providing hedge funds and their institutional investors with exactly the information needed to satisfy the SEC that a fund is accurately reporting its returns — potentially before the API process even starts. AIRAS is the first product to deliver objective and empirical analysis based on established financial research and mathematical optimisation of whether the return and NAVs reported by the manager are reported properly based on a manager’s reported investment allocations (by industry, by country, and by asset type). AIRAS provides an independent authentication of what the hedge fund managers are reporting — hence our slogan of "Trust But Verify".
Axiom Valuation has been and continues to be a strong advocate for increasing transparency in the reporting of returns for alternative investments and for making the auditing process for institutional investors in alternatives more analytically driven.
"We applaud the SEC for pursuing the use of analytical tools to more effectively screen for potential fraud and/or misreporting," says Dr Stanley Jay Feldman (pictured), the Chairman of Axiom Valuation and the principal architect of the AIRAS capability. "We have shared our approach and research with the SEC and with some major financial service companies as part of the effort to raise awareness of what the analytical possibilities are for identifying possible misreporting situations. The AIRAS approach has the advantage of being able to identify a Madoff-type fraud, where the reported returns were not above market benchmarks."
