Hedge funds are flexible investment vehicles, built on the premise that their investors are financially “sophisticated” and aware of the inherent risks in these investments. But even these sophisticated investors can fall victim to fraud.

Some of the largest and most well-known fraud cases have been perpetrated by hedge fund managers — just look at Madoff. While each hedge fund fraud is not equal, there are some high level red-flag indicators that investors can look out for.

As a starting point, investors should make sure to understand the strategy of the fund. Be wary of strategies that are too complicated to understand as this can often be an indication that something is amiss.

One step that every investor should carry out is to review the audited financial statements, together with the offering documents, other marketing material and representations made by the investment manager. The audited accounts should give information on the type of assets held which can assist in determining whether investments have been made outside stated strategies, restrictions, or representations. If audited financials are unreasonably delayed or unavailable, be concerned.

Consider the stated performance of the fund relative to the relevant market or indices. For instance, if an unleveraged, long-only gold fund is reporting 300 percent annual profits while the overall gold market is in decline, questions should be asked.

Investors should make sure they understand how fees are earned by the investment manager and to what extent they are linked to the investment valuations. It is desirable to have independent oversight of the valuations and/or a completely independent provider of the valuations. Pay special attention to any “qualification” in the audit opinion particularly regarding valuations.

The use of related-party vehicles for dealing with asset transactions or investing assets is another potential red flag. There may be a good reason for related-party transactions but this is an area fraught with potential conflicts and scope for misuse.

If such parties are identified, inquiries should be made to obtain an understanding of how these transactions fit into the overall investment strategy and if conflicts are properly managed.

Consider the qualifications, reputation and experience of those retained to provide services to the fund. Service providers should ideally be independent and reputable so they are able to ask the necessary questions should fraud be suspected. Be sceptical if a fund changes service providers and make sure you understand the reason behind the change.

Before you invest, it is worth conducting due diligence such as background checks and reviewing any current litigation any service providers might be involved in. Learning more about the investment manager, the directors, fund administrator or other service providers, identifying related parties, as well as ensuring a reputable accounting firm conducts their annual audit are necessary elements to any due diligence.

KRyS Global, a fraud investigation and asset recovery firm based in Bermuda, wrote this article as a way to increase community awareness about fraud. For avoidance of doubt, this article discussing red flags and due diligence is not intended to be exhaustive list of considerations before deciding to invest in hedge funds. For more information contact Mathew Clingerman, Managing Director, KRyS Global at Mathew.Clingerman@krys-global.com