LO 72.1: Identify reasons for the failures of funds in the past. * 1

LO 72.1: Identify reasons for the failures of funds in the past. * 1
Investors should be familiar with the reasons past funds have failed to ensure they can avoid investing in a failing fund. Following is a concise list of reasons past funds have failed. 1. Poor investment decisions. Could be a series of decisions (domino effect) or a very
calculated risk on a specific investment that backfired.
2. Fraud. Fraud could occur in several forms including accounting (e.g., misstating asset book values or misstating income), valuation (e.g., misstating asset market values), and theft of funds.
3. Extreme events. Events occurring that would otherwise occur with very low probability
or were unexpected (e.g., market crashes).
4. Excess leverage. Related to making poor investment decisions. Leverage goes both ways.
That is, it magnifies gains but also magnifies losses.
3. Lack of liquidity. Too many capital withdrawals and redemptions to honor at once,
thereby creating a squeeze on cash flow and an inability to meet all capital withdrawals and redemptions.
6. Poor controls. Closely related to fraud. Lack of supervision could result in excessive
risks being taken that lead to losses large enough to bankrupt the fund.
2018 Kaplan, Inc.
Page 151
Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
Insufficient questioning. Often in a committee-style decision-making process, there may be a dominant member who sways the decision and/or members who are afraid to voice any valid concerns over information they have discovered that would question the merits of the investment manager and/or investment. Ideally, all due diligence team members should be encouraged to play the role of devils advocate when appropriate and raise reasonable concerns as early as possible, especially before they reach the committee stage.
Insufficient attention to returns. Investment funds attempting to reduce operational risk sometimes overcompensate by implementing excessive controls and may end up bearing too many expenses and not generating enough returns. Ideally, there is a healthy balance between generating strong returns while taking on a reasonable level of risk.
D u e D il ig e n c e El e m e n t s

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