Why active fund managers can miss red flags for fraud

High-profile collapse of fintech firm raises questions on managers' ability and inclination to look under the hood

Why active fund managers can miss red flags for fraud

For many investors, the collapse of German fintech darling Wirecard after revelations of a massive 1.9-billion-euro gap in its balance sheet was a rude awakening. Unfortunately, those investors include managers of funds that bet on the stock, apparently oblivious to the risk that it carried.

Of course, not everyone was caught wrong-footed. Some were able to correctly place short bets against the scandal-hit payment company as they detected discrepancies and hints of questionable management. But for the most part, it seems fund managers with long positions on the company were, intentionally or not, blind to the ongoing fraud.

One possible reason, as reported by Barron’s, is that most fund managers don’t engage in the forensic accounting needed to uncover that kind of fraud. Instead, their skills lie more in reading top-level financial information, which can tell an entirely different story.

“The accounting world is substantively different from the world of finance in estimating the intrinsic value of a company,” money manager Norm Conley of JAG Capital Management told Barron’s. While he doesn’t employ people with capabilities in forensic analysis, Conley said he almost always sells stocks when “credible allegations arise of accounting improprieties.”

Forensic analysis might make sense from a portfolio risk-management standpoint. But according to Bob Olstein of Olstein All Cap Value, a fund manager with 52 years of forensic accounting experience, the practice is time-intensive and doesn’t always turn up any compelling or actionable information. And even if it does, it can take years before markets and regulators see and respond to it.

That feeds into the second reason why managers may not apply forensic accounting in their fund management: there’s immense temptation to own a hot name even if they realize it’s suspicious. Speaking to Barron’s, Sam Stewart, co-manager of Seven Canyons World Innovators, said stock-picking PMs have to deal with two types of pressure: “One is the benchmark you’re trying to keep up with; the other comes from investors.”

A stock can go from hero to zero in a heartbeat, depending on when a damning story or event emerges. In other words, by the time news of corporate fraud breaks, it may be too late for investors to escape their long positions as the company in question accelerates toward financial ruin.

Forensic accounting is a powerful tool, but managers who want more assurance before selling a stock short can look at a constellation of other indicators. In the case of Wirecard, Fahmi Quadir, the short-selling founder of Safkhet Capital, said there were other red flags. Aside from a dependence on processing gambling and pornography transactions – which typically see a high incidence of credit-card chargebacks from identity-theft transactions – she said it had a major subsidiary based in Dubai, which she described as a “black box jurisdiction” that provides few details on financial transactions.

“With major company collapses, accounting fraud is symptomatic of a much broader cultural systemic problem,” Quadir said.


Follow WP on FacebookLinkedIn and Twitter