Significant numbers of hedge-fund managers purposefully and routinely avoid reporting losses by marking up the value of their portfolios, according to research from the Vanderbilt Owen Graduate School of Management.
In the wake of the sub-prime mortgage crisis and its effect on global financial markets, the analysis adds to the debate over hedge-fund regulation. Most hedge funds–private investment funds open only to a limited range of investors–are not registered with the Securities and Exchange Commission and are audited less frequently than other investment vehicles.
In-depth analysis of more than 4,200 hedge funds found a significant number of distortions–nearly 10 percent–in hedge-fund returns. These distortions were absent in the three months leading up to an audit or when funds were invested in more liquid securities such as common stock.
Overall, funds tend to report small monthly gains more frequently than small monthly losses, suggesting that hedge-fund managers tend to round up returns to make sure they are slightly positive, rather than adjusting both gains and losses. The study’s results, say researchers, point toward purposeful avoidance of reporting losses.
“This type of manipulation could result in investors underestimating the potential for future losses or overestimating the performance of hedge-fund managers,” says Nicolas P.B. Bollen, E. Bronson Ingram Research Professor and associate professor of management. “Perhaps even more worrisome, this manipulation could be indicative of even more serious violations of an adviser’s fiduciary responsibility.”
Using data from the Center for International Securities and Derivatives Markets, Bollen and Veronika K. Pool of Indiana University’s Kelley School of Business analyzed more than 215,000 hedge-fund return observations from 1994 to 2005. Their research debunks the argument that historically low numbers of fraud cases prosecuted by the SEC indicates additional oversight is unwarranted.
Investors should question the accuracy of hedge-fund returns, says Bollen, and exercise caution when using the number of positive returns as a measure of fund performance. “If a hedge fund is inflating returns and concealing losses, an investor who withdraws capital following a month or two of return inflation would benefit from somewhat overvalued fund shares,” he says, “but investors who deposit capital–which would be the more usual response in such a situation–would likely suffer.”
© 2013 Vanderbilt University
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