Alternative Investment Fraud and its Implications for

[Karl]

Jamaica.

Article sent to me via email. -

-----------

Alternative Investment Fraud and its Implications for Jamaican Alternative Investors

Joseph Bucknor and Michael Lamont

December 12, 2007

Background:
Despite the ongoing controversy over the legitimacy of the returns (10% per month) claimed by alternative investment vehicles that have been operating in Jamaica or targeting Jamaican investors, very little substantive literature has been written from an academic or practitioner perspective to explain why the actual returns claimed by such vehicles may be less stellar than reported. Some investors who have been receiving monthly nominal or cash distributions of 10% staunchly defend these investment vehicles while lambasting traditional financial institutions. Their detractors have countered that these results are “too good to be true,” and that these alternative investment vehicles are just Ponzi or pyramid schemes disguised as investment clubs or financial institutions. Based on a December 7 article in the Jamaica Observer entitled Hylton gets death threats, contributions to these alternative investment vehicles have surpassed JAD 200 billion (approximately USD 3 billion). Given the size of contributions, the fallout from frauds at these institutions has massive negative implications for the Jamaica people. As evident from unrests that swept Albania in 1997 following the failure of several pyramid schemes, the potential repercussions from fraud at these entities go well beyond the actual sums invested and suggest that this topic deserves more than just a cursory review. This paper aims to enlighten the reader about the nature of hedge fund fraud, to evaluate the probability of fraud at these alternative investment vehicles, and to make recommendations to investors and potential investors so that they can avoid the pitfalls of hedge fund fraud.

Hedge Fund Fraud:
Since January 2000, the United States Securities Exchange Commission (“SEC”) has brought more than 50 enforcement actions (the “Actions”) against hedge fund advisers. My review of a sample of the Actions uncovered some common elements of hedge fund fraud and also dispels some popular fallacies that may lure alternative investors into fraudulent schemes. A review of a sample of the Actions identified three conditions -- (1) absence of third-party financial data verification, (2) avoidance of registration with regulatory bodies, and (3) earnings management – that, when coexisting together, may provide strong evidence of hedge fund fraud.

Hedge fund fraud typically involves either or both of misrepresentation (examples include Lancer and International Management Associates ) and misappropriation (examples include Vestron Financial Corp and Chabot Investments). In cases involving misrepresentation, the investment manager overstates the fund’s gross assets, net asset value (“NAV” or capital), and returns to disguise legitimate losses or to attract new subscriptions (i.e., capital contributions). With misappropriation, the investment adviser uses the fund’s assets for other than their intended purpose, typically to fund the investment adviser’s lavish lifestyle. Misappropriation seldom occurs without misrepresentation, which is required to mask or prolong the initial misappropriation.

In cases where there is an absence of third-party financial data verification, the hedge fund manager fails to employ a “legitimate” third-party full-service administrator or auditor to verify the fund’s assets, NAV, or returns. The term legitimate is used to indicate that in certain cases such as Wood River Capital and Bayou Management, the hedge fund adviser either lied outright about the presence of a third-party administrator or failed to disclose conflicts of interest ties with listed third-party service providers. As evident from the case of Edward J. Strafaci, where Price Waterhouse served as the auditor of Lipper & Co prior to the SEC bringing the enforcement action against the Fund’s portfolio manager, the presence of reputable third-party service providers is not in itself a preclusion of fraud; however, it is certainly a major deterrent to malfeasance.

In December 2004, the SEC published Registration Under the Advisers Act of Certain Hedge Fund Advisers (the “Registration”), which sought to make it mandatory for investment advisers that meet certain criteria -- have more than USD 30 million in assets, have at least 15 investors, and allow investors to withdraw their investment within two years -- to register with the SEC. One of the key motivations that the SEC cited for the Registration, which was later repealed, was the “deterrence of fraud.” The SEC revealed, “Our examination staff uncovered, during routine or sweep exams, five of the eight cases we brought against registered hedge fund advisers, and two of the cases involving unregistered advisers originated out of examinations of related persons that were registered with us.” Given that the SEC brought more than 50 such cases over the period, we can infer that no more than 16% of such cases were against registered hedge fund advisers; said differently, at least 84% of the Actions were against unregistered investment advisers. The SEC noted that while registration under the Advisers Act will not result in it eliminating, or even identifying, every fraud, the prospect of an SEC examination, however, increases the risk of getting caught, and thus will deter wrongdoers. The more than 5:1 ratio of enforcement actions brought against unregistered advisers to those brought against registered advisers supports the SEC’s assertion.

As noted above, investment managers engaged in fraud invariably misrepresent the returns of the funds under their management to attract new capital and to limit investor redemptions. Such misrepresentation, or earnings management, typically takes two forms: (1) overstatement of the funds’ returns relative to those of their peers and (2) understatement of the funds’ volatility (or standard deviation) of returns relative to those of their peers. Given Jamaica’s preoccupation with the foreign exchange (“FX”) and venture capital (“VC”) trading strategies that are purported to be yielding 10% per month with little variability, this paper compares the pro forma returns of two such hypothetical funds to the returns of relevant style indices.

cont --->

[Karl]

Cont: Pg 2

Alternative Investment Fraud and its Implications for Jamaican Alternative Investors

Joseph Bucknor and Michael Lamont

December 12, 2007

FX Return Analysis
We prepared the accompanying table that compares the annualized returns of relevant hedge fund indexes to those of the Jamaican FX strategy (“Jam FX”). For Jam FX, we assumed that the Fund had a series of consecutive three-month returns of 8%, 10%, and 12%, to introduce some volatility into its return. Most major hedge fund data providers do not have a pure FX component. FX trading is typically a sub-strategy of a global macro, multi-strategy, managed futures, or emerging market strategy. There are a few data providers -- Barclay, CISDM, Parker, and Stark – that provide a purer view of returns on FX strategies with their CTA currency indices. We calculated the annualized returns and standard deviations of each of the hedge fund strategies using monthly data from the CSFB/Tremont Hedge Fund Index. For the pure FX strategies, we used data from Barclay and CISDM. We also calculated the Sharpe Ratio, a standard measure of risk-adjusted returns in the investment industry, for each of the indices and the Jam FX strategy.


The table clearly shows that Jam FX’s average annualized return and Sharpe Ratio are more than 10 times those of any of the indexes. Even more startling is that Jam FX’s average annualized return and Sharpe Ratio are more than 30 times those of the pure FX trading strategies. What is more implausible about the performance of Jam FX is that such performance has been reported over a period when FX funds as a whole seem to be underperforming. In her January 2007 article entitled Performance in the Currency Industry—Is the End Nigh?, Amy Middleton of Bank of America notes, “Performance (of hedge funds trading purely currency) has suffered over the past couple of years and this has led many to question how sustainable this popularity in currency will be.” Based on interviews with six hedge fund credit analysts that cover a total of almost 700 hedge fund clients, we have knowledge of only one fund with an average annualized return of over 200% over the same 5-year period. That said, this fund operates in a relatively immature market and its returns over the study period were accompanied by significantly higher volatility (annualized standard deviation of over 60% versus 5.7% for Jam FX) than that calculated for Jam FX and its Sharpe Ratio was less than a tenth of that computed for Jam FX. So, while the reputed returns for Jam FX are not impossible, they are highly improbable.

VC Return Analysis:
Compared to the hedge fund industry, the venture capital industry has a relatively limited number of indices that track industry performance. In the US venture capital industry, the standard measure of performance is the private equity performance index (“PEPI”) prepared by Thomson Financials in conjunction with the National Venture Capital Association. There are four PEPI indices: Early/Seed VC, Balanced VC, Later Stage VC and All Venture. Given that (1) we do not have full transparency on Jam VC’s portfolio and (2) Jam VC appears to have a portfolio with mixture of current earning investments (e.g., sale of phone cards) and more illiquid early stage investments (e.g., large undeveloped real estate acquisition), then the Balanced VC PEPI (i.e., the index that tracks the performance of venture capital funds that invest in a blend of early stage and late stage venture capital opportunities) appears to be the most relevant index for this exercise. According to the PEPI, Balanced VC funds posted average annualized returns of 21.8%, 31.2%, and 8% for the one year, three year and five year periods, respectively, ended June 30, 2007. The pro forma returns for Jam VC are substantially higher than those of the PEPI index; however, we must note that, because of the wide disparity in the portfolio holdings amongst VC funds and additional issues such as barriers to entry and informational asymmetry, the return distribution of VC funds can be extremely wide (“boom or bust”). Accordingly, the presence of outsized returns is not, in itself, evidence of fraud.

What is most surprising about the performance of Jam VC’s return is its wide deviation from the J-Curve expectation. It is widely held that venture capital fund returns fit a J-Curve profile, when the returns of the fund (Y axis) are mapped against the age of the fund (X axis). During the early years of the typical venture capital fund, returns grow increasingly negative as capital is deployed and expenses are incurred to acquire and develop early stage investments or to acquire and revitalize late stage opportunities. The typical venture capital fund does not make any meaningful cash distributions during the first three to five years of its life (the “Investment Period”) and it is very difficult to assess the profitability of the fund during this period. At the end of the Investment Period, the venture capital fund should start to see returns on its investment through cash flows from ongoing operations or sales (trade sale, IPO, etc.,) of its portfolio companies. Given this return profile for the average venture capital fund (i.e., negative free cash flow and limited distributions to investors), we find it surprising that a balanced VC fund could be claiming such staggering returns and making such large income distributions so early in its life cycle.

[Karl]

Cont. Pg 3

Alternative Investment Fraud and its Implications for Jamaican Alternative Investors

Joseph Bucknor and Michael Lamont

December 12, 2007

Fallacies:

Detractors of the popular investment vehicles in Jamaica do not understand the sophisticated trading models used by these vehicles.
Some of the comments from supporters of Jam FX suggest that the detractors of Jam FX do not understand these new sophisticated FX strategies. Jamaica may have a relatively unsophisticated financial derivative marketplace, so this proposition may be accurate for a large section of the marketplace; however, the fact of the matter is that (1) there are Jamaicans at home and abroad who are intimately familiar with the financial markets and (2) the FX market is a well developed, liquid, and transparent market. In fact, currency futures were the first financial futures traded on a recognized exchange when they were introduced on the Chicago Mercantile Exchange (“CME”) in 1972. Consequently, the FX market is viewed by financial market participants as a mature market. One feature of mature markets is that the temporary inefficiencies that may have contributed to some traders reaping outsized returns in less mature markets are arbitraged away by competing traders; thus, the type of returns purported by Jam FX is atypical of mature markets.

Jam FX and Jam VC investment advisers are just plain smarter than other investment managers:
Some have suggested that the investment advisers of these investment vehicles may just be plain smarter than other hedge fund advisers. Having read the bios of thousands of the top employees at over 100 hedge fund advisers and private equity firms, we find this proposition to be particularly presumptuous. The investment management industry, because of its large compensation packages relative to other industries, has been a magnet for extremely brilliant individuals with the highest academic qualifications in scientific, technical, legal, and business disciplines. For example, Dr. Saleem Josephs, the Jamaican who graduated from Columbia University in May 2006 with three graduate degrees, including a DDS, chose to work at Bear Stearns instead of taking up a career in dentistry. There are several funds with allocations to FX that have billions of USD in assets under management and that have a battery of Ph.D.’s and MBA’s from the top universities across the world complemented by artificial intelligence or systematic trading systems. The singular goal of human and machine is to maximize the funds’ risk adjusted returns while preserving capital. These systems use tools such as statistical analysis, complex optimization techniques, and data mining to comb the world’s financial markets in the relentless quest for alpha (i.e., excess returns). If a 200% annualized return with volatility of less than 10% is to be had in mature markets with no barriers to entry, these human and machine systems will quickly find it and compete it away.

So many people and so much money could not be wrong for so long:
Every other Jamaican seems to know someone who has invested in Jam FX or Jamaica VC and has been getting 10% monthly, either nominally or in cash. Based on the wide cross-section of Jamaicans who have invested money in Jam FX and Jam VC and who have revealed that they are receiving this 10% monthly income, some persons have strongly asserted that the funds are in fact legitimate trading vehicles. However, ongoing cash distributions over several years do not preclude the existence of fraud. For example, the fraud

committed by International Management Associates, which was run by an individual with Jamaican connections, was committed over a nine-year period (1997-2006) and duped over 500 investors, including many NFL players, of over USD 115 million. The fraud at Bayou Management was perpetrated over a seven-year period (1998-2005) and cost more than 200 investors over USD 250 million. The fraud at Manhattan Capital was conducted over a four-year period and cost over 250 investors more than USD $350 million.

Conclusion & Recommendations:
The evidence – no third-party full-service administration or audit, avoidance of registration with regulatory bodies, and return profiles that are inconsistent with returns of stated investment styles -- strongly suggests that the investment advisers at both Jam FX or Jam VC may be engaged in fraudulent conduct. The recommendation to investors and potential investors in these and similar entities is to mandate that the investment adviser hire a reputable and unaffiliated third-party full-service administrator and a financial statement auditor. A list of the top hedge fund administrators may be found at HFN Hedge Fund Administrator Study and a list of leading financial statement auditors may be found at Top 40 Accounting Firms. The combined annual cost of these service providers is generally less than 0.5% of AUM -– a relatively small price to pay for the security of knowing whether the 10% per month that you that you are receiving nominally or in cash is really a return on your investment. If your investment adviser is unwilling to take these relatively inexpensive steps, such reluctance should be a strong signal to take your money, or what is left of it, elsewhere.

College, universities, and other providers of financial training in Jamaican can help Jamaican investors by supplementing the curricula on traditional financial markets and products at these institutions with courses on alternative investments. Such institutions should liaise with organizations such as CFA Institute, Chartered Alternative Investment Analyst Association ("CAIA"), and Global Association of Risk Professionals ("GARP"), all of which have programs that extensively cover alternative investments, to provide or develop programs that cover alternative investments.

Jamaican regulatory and legal bodies entrusted with the task of protecting Jamaican investors and maintaining the integrity of Jamaica’s financial markets should look into having some of their members trained in the detection of alternative investment fraud. Similar to what was done by the SEC, which adopted a new antifraud rule under the Investment Advisers Act in July 2007, the Jamaican regulators should enact an antifraud statute that would give such regulatory bodies the power to investigate and prosecute persons and institutions suspected of defrauding investors, whether or not such suspects are registered with these regulatory bodies.