Book 5. Risk and Investment Management

FRM Part 2

IM 11. Predicting Fraud by Investment Managers

Presented by: Sudhanshu

Module 1. Predicting Fraud by Investment Managers

Module 1. Predicting Fraud by Investment Managers

Topic 1. Using Disclosures to Predict Fraud

Topic 2. Predictive Variables From Form ADV

Topic 3. Predicting Different Types of Fraud

Topic 4. Costs of Fraud Prediction

Topic 5. Ways to improve fraud detection

Topic 1. Using Disclosures to Predict Fraud

• Why is predicting fraud important?

  • Fraud often results in a total loss of capital for investors.

  • There are no U.S. laws mandating investment advisor experience or prohibiting conflicts of interest, only that these must be disclosed.

• The role of Form ADV

  • The Investment Advisers Act of 1940 requires advisors to file Form ADV.

  • This form discloses past regulatory and legal violations, and potential conflicts of interest.

  • Investors must use this information to predict and avoid fraud.

Topic 2. Predictive Variables From Form ADV 

• Filing Requirements: Investment advisors managing over $25 million must file Form ADV annually or upon material change with the SEC.

• Items reported on Form ADV (apart from past fraudulent activity):

  • Strong Fraud Predictors:​

    • Conflicts of interest: Firm recommends securities it owns, transacts with clients, or receives referral fees → higher fraud likelihood
    • Broker-dealer association: Firm affiliated with broker-dealer loses external monitoring → significantly higher fraud risk (front-running, overcharging)
    • ICA registration: Counterintuitively predicts fraud from theft due to vulnerable client base (but reduces misrepresentation risk)
    • Investor size: The smaller (larger) the firm’s investors, the more (less) likely fraud will occur.
    • Agent clients: More clients who are agents (e.g., pension fund managers) → higher fraud likelihood
  • ​​Non-significant Fraud Predictors:
    • ​Soft dollar arrangements: Potential conflict exists but does not predict fraud
    • Firm as custodian: Lacks third-party oversight but does not predict greater fraud
    • Dedicated CCO: Does not significantly reduce theft fraud (but reduces misrepresentation risk)
    • Majority employee-owned: No significant evidence of greater fraud likelihood
    • Hedge fund management: Opaque nature suggests risk but no significant evidence (may understate due to reduced detection)

• Investors could use the information reported on Form ADV to reasonably predict fraud in the future.

Practice Questions: Q1

Q1. In the United States, investment advisors are required to file Form ADV annually or whenever there is a material change when they manage at least how much in assets?
A. $10 million.
B. $25 million.
C. $50 million.
D. $100 million.

Practice Questions: Q1 Answer

Explanation: B is correct.

In the United States, investment advisors who manage more than $25 million are required to file Form ADV annually or whenever there is a material change.

Practice Questions: Q2

Q2. Which of the following factors would lead to an increased likelihood of fraud perpetrated by an investment firm?
A. Clients who are agents.
B. The firm serving as a custodian.
C. Existence of soft dollar arrangements.
D. Firms that are majority owned by employees.

Practice Questions: Q2 Answer

Explanation: A is correct.

Firms that have more clients who are agents (e.g., pension fund manager who is the client but not a direct benefiiciary of the funds) are more likely to engage in fraud.

Practice Questions: Q3

Q3. Which of the following factors would lead to a decreased likelihood of fraud perpetrated by an investment firm?
A. Firms with larger clients.
B. Firms that manage hedge funds.
C. Firms with an appointed chief compliance officer (CCO).
D. Firms that are registered under the Investment Company Act of 1940.

Practice Questions: Q3 Answer

Explanation: A is correct.

The smaller (larger) the firm’s investors, the more (less) likely fraud will occur.

Topic 3. Predicting Different Types of Fraud

• Two Categories of Fraud: Theft and fraudulent misrepresentation

• Theft includes Ponzi schemes, self-dealing, and misappropriation.

  • Firms with any past regulatory violations, firms that pay referral fees, firms with mainly smaller clients, and firms with mainly clients who are agents have a high probability of committing theft

• Fraudulent Misrepresentation: Intentional misleading of investors.

  • Past violations are a strong predictor.

  • Firms registered under the ICA of 1940 or with an appointed CCO suggest a reduction in the risk of fraudulent misrepresentation due to greater audit requirements or internal monitoring respectively.

• Firm-wide vs. Rogue Employee Fraud:

  • Firm-wide fraud by senior management is harder to predict.

  • Weaknesses in internal controls are more likely to lead to rogue employee fraud.

Topic 4. Costs of Fraud Prediction

• Implementing fraud prediction is a cost-benefit decision. The cost of 100% fraud eradication would likely exceed the benefits.
• Fraud Risk Premium: Some investors may be willing to accept more fraud risk for lower fees or higher returns. In that case, having strong fraud prediction methods may lower the amount of fraud but also hurt those investors who were willing to take on fraud risk. Those investors would not be able to earn a fraud risk premium.
• Free-Rider Problem: The costs for a single investor to obtain and analyze all relevant data may be too high, but if they do, other investors would benefit without contributing.
• Short Sale Restrictions: The benefits of identifying fraud are limited because investors can only avoid the investment, not profit from its decline through short selling.

Practice Questions: Q4

Q4. The free-rider problem suggests that the costs of obtaining relevant data and estimating fraud risk may be:
A. higher than the benefits for investors as a whole and for single investors.
B. higher than the benefits for investors as a whole and lower than the benefits for single investors.

C. lower than the benefits for investors as a whole and for single investors.
D. lower than the benefits for investors as a whole and higher than the benefits for single investors.

Practice Questions: Q4 Answer

Explanation: D is correct.

The costs of obtaining relevant data and estimating fraud risk may be lower than the benefits for investors as a whole. However, the costs may be too high for a single investor to bear, and even if the single investor were to bear it, the other investors who benefit would not likely contribute to the costs (i.e., free-rider problem).

Topic 5. Ways to Improve Fraud Prediction

• Historical Filings:

  • Previously, only the most recent Form ADV was available, hiding past fraudulent activity.

  • The SEC now provides historical filings.

• Standardized Format:

  • The historical data was initially difficult to access due to being in an encoded, non-user-friendly format.

  • The SEC now provides the information in a standardized format, making it practical for investors to perform due diligence.

Practice Questions: Q5

Q5. Which Form ADV and format is now made available for investors by the SEC?
A. Current Form ADV in encoded format.
B. Current Form ADV in standardized format.
C. Current and historical Form ADV in encoded format.
D. Current and historical Form ADV in standardized format.

Practice Questions: Q5 Answer

Explanation: D is correct.

To improve transparency, the SEC has now made the current and historical Form ADVs available to investors in a user-friendly (standardized) format.