Abstract

Using a panel of mandatory SEC disclosure filings we test the predictability of investment fraud. We find that past regulatory and legal violations, conflicts of interest, and monitoring, are significantly associated with future fraud. Avoiding the 5% of firms with the highest fraud risk allows investors to avoid 29% of investment frauds, and over 40% of the total dollar losses from fraud. Even though our predictions are based on publicly available information, we do not find evidence that investors are compensated for fraud risk through superior performance or lower fees. The results suggest that the currently required disclosures contain relevant information but this information is not fully utilized by investors. We suggest changes in SEC disclosure policy that increase investors' ability to detect fraud at minimal cost.

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