SEC Ups Its Game to Identify Rogue Firms

It is the Securities and Exchange Commission's new "most-wanted" list: a chart covered with handwritten notes, yellow highlighter and the names of about 100 hedge funds.

The hedge funds have one thing in common: Their performance seems too good to be true, with some trouncing the overall market and others churning out modest results without ever suffering a down month. Some funds on the list stumble but still always outperform rival hedge funds.

"There is serious fraud in this space, and we have been attacking it," said Bruce Karpati, co-chief of the SEC's asset-management enforcement unit. The hedge-fund chart dominates a corner of his lower Manhattan office.

The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won't say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the "aberrational performance initiative."

One hedge fund sued by the SEC reported annual returns of more than 25% by allegedly overvaluing its assets, including Nigerian warrants. A hedge fund of funds achieved its seemingly great returns by allegedly overriding internal controls on vetting outside funds, causing it to sink investor money into frauds.

Encouraged by the results so far, SEC officials are widening the computer-powered scrutiny to mutual funds and private-equity funds. That means data on more than 20,000 funds are being fed into the SEC's computers or soon will be.

The enforcement-by-the-numbers machine isn't popular on Wall Street, where some investment managers are worried they might get snagged in an investigation simply because their numbers look too good.

SEC enforcement chief Robert Khuzami rattled some people this year when he suggested that any fund with returns that steadily topped market indexes by 3% could catch the agency's eye. The SEC now says it doesn't set such thresholds.

"There are people out there who have been committing fraud, and we want to get them and get them out of the system," said Robert Leonard, a partner at law firm Bingham McCutchen LLP who represents hedge funds. "I'm concerned there probably will be some chilling effect for managers who are knocking the cover off the ball."

Robert Kaplan, the other co-chief of the SEC's asset-management enforcement unit, said it isn't so simple. After the SEC's machine spits out the name of a specific hedge fund, the SEC's 65-person asset-management enforcement unit starts looking for an explanation for the numbers.

Some of the hedge funds on the list in Mr. Karpati's office are "just very good" performers, Mr. Kaplan said, while others seemed suspicious but the activity wasn't clear-cut enough for the SEC to launch an investigation or file a civil lawsuit.

Mr. Kaplan wouldn't say how many hedge funds flagged by the "aberrational performance initiative" wind up as the target of an SEC probe. But the results were encouraging when the SEC tested the computer system in 2009, he said. "We spotted several cases that we'd recently filed and some others we were already investigating," Mr. Kaplan said.

The system is designed partly to detect returns that barely budge when markets are volatile. That might have set off alarms inside the SEC about Mr. Madoff. The SEC has been criticized for failing to identify the Ponzi scheme and for its failure to respond to whistleblowers and their warnings that Mr. Madoff's operations were a fraud. Mr. Madoff's firm collapsed in December 2008, and he is serving a 150-year prison sentence.

Among the civil-fraud suits that have resulted from the initiative is one filed against ThinkStrategy Capital Management LLP, which attracted SEC attention partly because it seemed able to defy stock-market gravity.

In 2008, ThinkStrategy reported a 4.6% return on its Capital Fund-A hedge fund. It was the sixth year in a row that Chetan Kapur, a 36-year-old New Yorker, seemed to have a Midas touch. In contrast, the average hedge fund fell roughly 19% in 2008, with losses in eight of the year's 12 months, according to data from Hedge Fund Research Inc.

The SEC alleged in its civil-fraud suit against Mr. Kapur that the 4.6% return figure was faked. The hedge fund actually had a 90% loss in 2008, according to the SEC's lawsuit.

The SEC accused Mr. Kapur of continuing to report positive returns for the hedge fund even after it was liquidated and ceased trading, as a way of attracting investors to his other funds. Mr. Kapur also repeatedly inflated his firm's assets under management in investor reports and invented a nonexistent management team, the SEC alleged in its civil-fraud suit.

Without admitting or denying wrongdoing, Mr. Kapur agreed to a lifetime ban from the investment industry. A federal court soon will rule on penalties in the case. Mr. Kapur's lawyer, Sam Lieberman of Sadis & Goldberg LLP, said the settlement is a "favorable development that will allow him to focus on his new business outside the securities industry."

Messrs. Karpati and Kaplan said the data crunching has helped trigger a number of investigations. For private-equity funds, SEC enforcement officials are zooming in on excessive valuations of funds' holdings.

Mr. Kaplan said the number crunching on mutual funds has led to an unspecified number of probes "we're doing that come from similar analysis of outliers."