“Too-good-to-be-true” hedge funds are now undergoing intense scrutiny courtesy of the Securities and Exchange Commission (SEC) and a new computer system designed to analyze funds whose over-the-top performance could potentially indicate fraud.

The SEC began developing its computerized hedge fund analyzer in 2009; today it analyzes monthly returns for thousands of hedge funds. Officials at the SEC are keeping mum on exactly how the system works, but several civil-fraud lawsuits have been filed as a result of the effort.

One hedge fund that was sued by the SEC reported annual returns of more than 25% by allegedly overvaluing its assets, according to a Dec. 27 article by the Wall Street Journal. Another civil-fraud lawsuit involves ThinkStrategy Capital Management LLP and its Capital Fund-A hedge fund.

In 2008, Capital Fund-A reported a 4.6% return for the sixth year in a row. In comparison, 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.

In a reality, Capital Fund-A hedge fund actually had a 90% loss in 2008, according to the lawsuit filed by the SEC against the hedge fund’s manager, Chetan Kapur.

As reported in the WSJ article, the SEC alleges that Kapur continued to report positive returns for the Capital Fund-A hedge fund even after it was liquidated and ceased trading in order to attract investors to his other funds. The SEC also claims that Kapur repeatedly inflated his firm’s assets under management in investor reports and invented a nonexistent management team.

Without admitting or denying wrongdoing, Kapur agreed to a lifetime ban from the investment industry. A federal court will later decide on penalties in the case.

Several well-known life insurance carriers are making a surprise exit from the variable annuities business, while others are drastically scaling back their exposure or evaluating their participation in 2012.

The combination of a volatile stock market and a prolonged low-interest-rate environment has made it both difficult and expensive for life insurers to hedge variable annuities with living benefits, according to a Dec. 18 article by Investment News. As a result, many insurers are opting to limit their exposure to those hedging costs by exiting, or scaling back, their VA business, the article says.

In 2011, two big VA players – Genworth Financial and Sun Life Financial – announced that they would be leaving the variable annuities market. Others like Jackson National Life Insurance Co., MetLife Inc. and Prudential Financial are making plans to eliminate living benefits and limit investment options.

In addition, John Hancock Life Insurance Co. announced in November that it planned to withdraw an array of annuity products, including variable annuities, as well as limit distribution of existing products to only a small number of broker/dealers.

A variable annuity is a contract between you and an insurance company whereby the insurer agrees to make periodic payments to you beginning either immediately or at some future date. In return, you agree to purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.

In general, variable annuities are designed to be long-term investments to meet retirement and other long-range goals. They are not suitable for meeting short-term goals because substantial taxes and insurance company charges if money is withdrawn early. Variable annuities also involve certain investment risks.

Increasingly, variable annuities have become the focus of a growing number of legal disputes and investor complaints. Earlier this year, an arbitration panel of the Financial Industry Regulatory Authority (FINRA) awarded a Texas man and the estate of his deceased wife $1.7 million, after finding that an independent contractor, Paul Davis of Raymond James Financial Services, sold life insurance and variable annuity products that were inappropriate investments given the couple’s age and risk tolerance.

According to FINRA’s ruling, Davis sold the couple’s $3.8 million portfolio (which had been heavily invested in municipal bonds) in favor of life insurance and annuity products. He then invested in one annuity after another from 2002-2006, causing the Texas couple substantial financial penalties.

College Illinois, the prepaid tuition program for Illinois residents, has suspended sales of new contracts amid reports that the $1 billion program is facing a 30% shortfall.

Earlier this year, an investigation by Crain’s Chicago Business revealed that the College Illinois Prepaid Tuition Program had the greatest deficit of any prepaid tuition program in the United States and that the fund was plowing money into unconventional – and risky – investments to close the gap. Moreover, many parents were shocked to learn that the program itself was not guaranteed by the state if it came up short on cash.

More than 30,000 Illinois families hold contracts in College Illinois. The plan allows parents to lock in tuition costs at public universities at today’s prices before their children actually go to college.

Kym Hubbard, chairman of the Illinois Student Assistance Commission, says the commission plans to make recommendations to the governor and lawmakers early next year on what can be done to fix College Illinois. Those recommendations are likely to include major changes to the 13-year-old program. Those changes could mean universities, parents or both would have to plug the gap between what the plan accumulates and actual tuitions, according to a Dec. 13 story by Investment News.

Dec. 11th marked the three-year anniversary of the Bernard Madoff debacle. The mastermind behind the biggest Ponzi scheme – $65 billion – in U.S. history spent the day in North Carolina, in a medium-security prison, where he is serving a 150-year prison sentence. But for the investors who lost their money to Madoff, the day is constant reminder of financial futures permanently destroyed and their lives forever altered.

The list of investors who became a victim to Madoff runs the gamut – from Hollywood actors to ordinary citizens. Fortunes were wiped out overnight, as were middle-class nest eggs and college savings. Many investors are still trying to get their money back.

As reported Dec. 11 by the New York Times, Madoff trustee Irving Picard has approved 2,425 claims as of Dec. 2 totaling almost $7.3 billion. But two-thirds of the 16,519 claims originally filed have been denied, either because claimants took out more cash from Madoff’s firm, Bernard L. Madoff Investment Securities LLC, than they paid in over the years or did not have an account directly with the firm, according to the article.

Some Madoff investors are like Alexandra Penney, a New York City photographer. Penney is relatively lucky. So far, she’s been able to keep her New York studio, which she feared she might have to let go after losing her life savings to Madoff. To date, she has been paid “a small fraction of my claims,” she said in the New York Times story.

“But I don’t think about Madoff at all, at all,” she said. “However, I have to think about the impact of what happened every day — whenever I stop to consider ‘Do I take a bus or walk?’ It is ever-present and it will always be.”

Private-placement lawsuits and investigations continue to make their presence known, much to the chagrin of the broker/dealers that touted some soured deals involving Provident Royalties. The latest B-D to face the music is Next Financial Group, which will pay $2 million in restitution to customers who purchased oil and natural gas private placements of Provident Royalties.

According to the Financial Industry Regulatory Authority (FINRA), Next Financial sold $20 million of three separate Provident private placements from July 2008 to January 2009. During that time, Next Financial’s due diligence was lacking, FINRA said.

“Despite the fact that Next received a specific fee related to the due diligence that was purportedly performed in connection with each offering, beyond reviewing the private-placement memorandum for the offerings, [Steven Nelson, vice president of investment products and services] did not perform adequate due diligence on the [Provident] offerings,” according to FINRA.

Two years ago, the Securities and Exchange Commission (SEC) charged Provident with fraud.

As reported Nov. 28 by Investment News, outside due diligence reports highlighted a number of red flags regarding the Provident offerings, as well as the fact that Next Financial and Steven Nelson “should have scrutinized each of the [Provident] offerings, given the purported high rate of returns.”

About 50 broker/dealers sold private placements in Provident, which raised $485 million from 7,700 investors between 2006 to 2009. At least 20 broker/dealers that sold Provident private placements have shut down or declared bankruptcy.

FINRA also levied fines of $50,000 on Next Financial and $10,000 on Nelson, who was suspended as a principal for six months.

Private placements have been a ongoing source of controversy – not to mention financial losses for investors – this year, with regulators filing fraud charges against issuers like Medical Capital Holdings and Provident Royalties.

Now a well known forensic accountant says that the broker/dealers behind the doomed private-placement deals failed miserably in their due-diligence responsibilities to investors.

As reported Nov. 25 by Investment News, Gordon Yale, a certified public account and principal of Yale & Co., contends that broker/dealers’ due diligence showed incredible “sloppiness” when touting private placements in Medical Capital and Provident. According to Yale, the actions by the broker/dealers exhibited the “same recklessness with which major investment banks conducted their mortgage-backed-securities business, but it was done by middle- or lower-tier firms and [with] a different set of products.”

Over the past year, regulators have issued several fines and sanctions against various broker/dealers that sold private placements in Medical Capital Holdings, Provident Royalties, and DBSI tenant-in-common exchanges. In September, the Financial Industry Regulatory Authority (FINRA) imposed a $10,000 fine and a six-month suspension against Brian Boppre, former president of Capital Financial Services. Capital Financial was a top seller of both Medical Capital and Provident Royalties notes. Both companies were charged with fraud by the Securities and Exchange Commission in 2009.

Another non-traded REIT has landed in hot water with regulators. The Financial Industry Regulatory Authority (FINRA) imposed a $300,000 fine against Wells Investment Securities over misleading marketing tied to Wells Timberland REIT.

In reaching the settlement, Wells Investment Securities neither admitted nor denied the charges.

According to FINRA, communications from Wells Securities about Wells Timberland contained misleading statements regarding its portfolio diversification, as well as its ability to make distributions and redemptions.

“By approving and distributing marketing materials with ambiguous and equivocal statements, Wells misled investors into thinking Wells Timberland was a REIT at a time when it was not a REIT,” said FINRA executive vice president and chief of enforcement Brad Bennett in a statement.

FINRA also found that Wells failed to have proper supervisory procedures in place to ensure that sensitive customer and proprietary information stored on laptops was adequately safeguarded.

As reported Nov. 22 by Investment News, this is not the first time that Wells Securities has had a run-in with regulators over REITs. In October 2003, FINRA’s precursor, NASD, sanctioned Wells Investment Securities for improperly rewarding broker/dealer representatives who sold the company’s REITs. Those rewards included lavish entertainment and travel perquisites. FINRA also censured Leo Wells, founder and chairman of Wells Real Estate Funds, suspending him from acting in a principal capacity for one year.

Wells Real Estate Funds is one of the largest sponsors of investments in the non-traded REIT industry, with $11 billion in assets and 250,000 investors.

A federal judge has decided that Morgan Stanley must face the music and defend itself in a lawsuit brought by 18 Singapore investors over failed structured products. Among the allegations, investors accuse Morgan Stanley of committing fraud in 2006 and 2007 when it sold them nearly $155 million of Pinnacle Notes structured products. The notes, which were linked to synthetic collateralized debt obligations (CDOs), lost almost 100% of their value amid the financial crisis.

Morgan Stanley tried to get the lawsuit dismissed, but District Judge Leonard Sand rejected its request.

“Defendants point to generalized warnings cautioning investors not to rely solely on the offering materials,” Judge Sand stated in this ruling. “But even a sophisticated investor armed with a bevy of accountants, financial advisors and lawyers could not have known that Morgan Stanley would select inherently risky underlying assets and short them.”

As reported Nov. 4 by Reuters, the October 2010 lawsuit is seeking class-action status. It is one of several lawsuits accusing banks of misleading investors into buying supposedly safe securities backed by risky debt, even as other investors or the banks themselves were actually shorting them.

In the Morgan Stanley case – Dandong et al. vs. Pinnacle Performance Ltd et al., U.S. District Court, Southern District of New York, No. 10-08086 – plaintiffs allege that the bank represented the Pinnacle Notes as “conservative” and that they would keep their principal safe.

Instead, Morgan Stanley allegedly invested their money into synthetic CDOs that were tied to risky companies. In addition, investors say they were kept in the dark to the fact that Morgan Stanley acted as a counterparty in the CDO deal whereby it collected one dollar for every dollar investors lost.

“Morgan Stanley designed the synthetic CDOs to fail,” the complaint said. “It placed itself on the side guaranteed to win (the “short” side) and placed plaintiffs and the class on the side guaranteed to lose (the “long” side).”

Synthetic exchange-traded funds (ETFs) have gotten a bad rap lately – and with good reason. Regulators and many financial experts believe that synthetic ETFs are too complex for retail investors and that they may not fully understand the counterparty and derivatives risks they are actually taking on.

Many synthetic exchange-traded funds rely on derivatives to generate returns instead of holding or owning the underlying securities as traditional ETFs do. Synthetic ETFs include inverse and leveraged funds. A leveraged ETF is designed to accelerate returns based on the rate of growth of the index being tracked. For example, if the underlying index moves up 3%, a 2x leveraged ETF would move up by 6%.

An inverse ETF does the opposite. It is designed to perform as the inverse of whatever index or benchmark is being tracked. Inverse ETFs funds work by using short selling, derivatives and other techniques involving leverage.

And with leverage, there always comes risk. As reported Nov. 17 by Investment News, Laurence D. Fink, chief executive officer of BlackRock, Inc., is a staunch critic of some exchange-traded funds. In particular, Fink takes issue with ETFs provided by Societe Generale SA.

“If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” said Fink in the Investment News story. Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.”

And therein is the problem.

Counterparty risk means there is a chance that the swap provider could go belly up, leaving investors out in the cold. Remember Lehman Brothers? Following Lehman’s collapse in 2008, many investors quickly discovered that their investments were essentially worthless.

The headline says it all: “Purgatory For MF Global Customers.” The story, appearing Nov. 16 in the Wall Street Journal, highlights the aftermath of MF Global’s bankruptcy filing and the consequences now facing MF Global clients.

MF Global filed for Chapter 11 bankruptcy on Oct. 31. More than two weeks later, some 33,000 customers are unable to access their money – “stuck in a sort of purgatory.” And it’s possible that customers may never get all of their money back.

“My entire business has come to a halt,” said Andrew Gochberg in the Wall Street Journal article. “I’m angry and I no longer have any confidence in our system.”

Gochberg had more than more than $1 million with MF Global – in what he and thousands of other investors thought were safe, protected accounts and accounts kept separate from MF Global’s own money.

But that apparently didn’t happen. After MF Global filed for bankruptcy protection, regulators discovered more than $600 million missing in customer money.

How did it happen? That’s the $64,000 – or, in MF Global’s case, the $600 million-dollar – question. It may have something to do with a little known finance rule called Regulation 1.25. Before 2000, the rule allowed futures brokers to take money from their customers’ accounts and invest that money in approved, relatively safe securities with high liquidity.

But, as reported in a Nov. 16 story by Bloomberg, things changed in December 2000 when the Commodities Futures Trading Commission amended Regulation 1.25. Now investments were permitted in “general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds.” In short, riskier investments were now allowed under Regulation 1.25.

More changes came in February 2004 and May 2005, with Regulation 1.25 amended even further so that firms like MF Global could do “internal repos” of customers’ deposits – i.e. take money from customer accounts and invest that money in the short term in a variety of high-risk securities.

And that, of course, ultimately led to the undoing of MF Global and the beginning of a financial nightmare for its clients.