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CSI: Outsized Returns

After Congress, the Federal Reserve, the Federal Housing Federal Agency and, last but not least, the Securities and Exchange Commission all failed to recognize the hazardous levels that mortgage-backed securities were reaching in 2008, regulators realized something was seriously wrong.

When Bernie Madoff's $17.3 billion Ponzi scheme finally caught up with him after three decades of false returns and botched SEC exams, the Commission knew it had to do more than require independent audits. That prompted the SEC to step up to the plate with a new, risk-based approach with the aim of seeing the bigger picture-anomalies in prices, sales practices, profits, performance, audits and custody, not to mention financial innovations-all to avoid another financial Armageddon-or crook.

This resulted in the SEC's creation of the Division of Risk, Strategy, and Financial Innovation, and, in 2009, a commitment of more money and resources for technologically aided investigations to parse through performance data on 20,000 hedge funds, mutual funds and private equity funds.

But the one, simple thing that could have tipped off federal regulators to the housing and credit crisis, not to mention Madoff's misdeeds, was simply this: Watergate's Deep Throat advice to "just ... follow the money."

The SEC is now cutting to the chase, with its own version of Crime Scene Investigation: Outsized Performance. SEC's Office of Compliance Inspections and Examinations has a handwritten, "most wanted" list of about 100 hedge funds with suspiciously outsized returns. This has already led to four civil suits, including one against hedge fund ThinkStrategy Capital Management, which claimed a 4.6% return on its Capital Fund-A fund in 2008-when the average hedge fund was negative 19%.

Looking back at the dot-com crash of 2000 and the Reserve Primary Fund's breaking the buck in 2008, we now know that the same principal applies to blow-ups and outsized risk. In 1999, more than 100 mutual funds delivered eye-popping returns of 100%-plus, yet, lured by the profits, investors kept piling in. In the mid-2000's, the son of Bruce Bent, who invented the money market mutual fund and was an evangelist of slow-but-steady returns, betrayed his father's principles by looking for yield in corporate, including ill-fated Lehman, paper.

There will be another financial crisis. There will be other scandals and other crooks. To spot them and not be duped, just follow the money.