Practical analysis for investment professionals
07 February 2012

Dubious Measures: Hedge Funds’ Reporting Draws Scrutiny

“In God we trust; all others bring data.”

At the beginning of each year, investors are bombarded with annual performance data from hedge funds. The above quote from U.S. statistician W. Edwards Deming came to mind after I read a recent article in the Wall Street Journal that gives good reason for investors to be suspicious/skeptical about the returns that hedge funds report. The article discusses a study that found that approximately 7% of equity valuations reported by hedge funds in their quarterly filings with the SEC deviate from their actual closing prices (as measured by the Center for Research in Security Prices). In “The Valuation of Hedge Funds’ Equity Positions,” Gjergji Cici, Alexander Kempf, and Alexander Puetz found that the reported valuations deviated from the actual valuations by 2.5% and that the deviations were statistically significant for about 25% of the hedge fund advisers in their sample.

What? How can this be? “Say it ain’t so, Joe!”* Well, after doing some further investigating, I can unfortunately say that “it be!” As it turns out, there is a plethora of research that has documented a number of “irregularities” in self-reported hedge fund returns. These studies have found that some hedge funds reported smoothed returns, reported disproportionately more small positive returns than negative returns, and reported higher returns in December. For example:

  • In a May 2011 paper, “Do Hedge Funds Manipulate Stock Prices?” researchers found that hedge funds significantly manipulate stock prices on critical reporting dates (i.e., the end of the month and the end of the quarter). Stocks held by hedge funds tend to experience higher returns (prices) on the last day of the quarter, followed by a price reversal on the following day. The study found that stocks in the top quartile of hedge fund holdings exhibited abnormal returns of 30 bps on the last day of the quarter and a reversal of 25 bps on the following day. In addition, a significant part of this return is earned during the last minutes of the last day of the quarter and at an increasing rate toward the close of the trading session. The authors found that the evidence of manipulation is stronger for funds that have higher incentives for improving their ranking relative to their peers. In other words, top-performing funds have the strongest incentive to manipulate.
  • In “Do Hedge Funds Manage Their Reported Returns?” researchers found that hedge funds “inflate their returns in an opportunistic fashion to increase their compensation.” The study also found a December spike in the returns of hedge funds that stand to gain the most from good performance, funds that stand to lose the most from poor performance, and funds that have greater opportunities to engage in return inflation. The researchers provided evidence of two mechanisms used by hedge funds to manage returns. The first involves funds underreporting their returns in the early part of the year to create reserves for possible poor performance late in the year (think cookie jar reserves in earnings management). If unused by the end of the year, these reserves are added to the December return. The second mechanism involves “pushing up the security prices at the end of December through last-minute buying, which is followed by price reversals in January.”
  • In a 2007 paper, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution,” the authors found a discontinuity in reported hedge fund returns: The number of small gains far exceeded the number of small losses. Over a 10-year period, they found a statistically significant lack of reported returns that were just below zero and a statistically significant abundance of reported returns that are just above zero. In other words, hedge funds are loath to report negative or flat returns. They attributed this phenomenon to the fact that investors like funds with fewer reported monthly negative returns. They conclude that the size of management and incentive fees, combined with the sensitivity of investor capital flow to performance, provides a strong motivation to report positive returns.

So, let’s discuss the ethical dimensions of these situations and three of the CFA Institute Standards of Professional Conduct that are particularly relevant:

  • Standard I (C) – Professionalism: Misrepresentation. Misrepresentation is defined as “any untrue statement or omission of fact or any statement that is otherwise false or misleading.” Smoothing returns, selecting “flattering prices to value illiquid securities,” and other practices that these researchers discovered would definitely qualify as misrepresentation. Because of the information asymmetry between investment professionals and their clients, trust is the foundation of the investment industry. In order for the industry to survive and flourish, investors must be able to rely on the statements and information that investment professionals provide them. The misreporting of returns not only diminishes trust but also undermines the integrity of capital markets. If we as investment professionals want to restore integrity and trust in our profession, we must be aware of what our colleagues are doing, and we need to help put an end to these practices.
  • Standard III (A) – Duties to Clients: Loyalty, Prudence, and Care. According to this standard, investment professionals have “a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment.” They “must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.” When hedge fund managers “manage” returns, they are definitely putting their interests and those of their firm before those of their clients. Higher returns lead to higher management and incentive/performance fees as well as greater assets under management. Although small distortions in returns may not put a fund’s investors at risk, they can lead investors to underestimate the potential for losses and to overestimate the ability of hedge fund managers.
  • Standard III (D) – Duties to Clients: Performance Presentation. This standard covers any practice that would lead to misrepresentation of an investment professional’s performance record, whether the practice involves performance presentation or performance measurement. It prohibits misrepresentations of past performance and requires investment professionals to give a fair and complete presentation of performance information whenever communicating data with respect to the performance history of individual accounts, composites, or groups of accounts, or composites of an analyst’s or firm’s performance results. Reporting smoothed results, cherry-picking price estimates for illiquid securities, and misreporting returns are all violations of this standard.

So, what is being done about this? In 2011, the SEC launched the Aberrational Performance Inquiry. The Asset Management Unit of the SEC’s enforcement division “uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.” In December 2011, the SEC announced enforcement actions against three separate advisory firms and six individuals for various types of misconduct, including improper use of fund assets, fraudulent valuations, and misrepresentation of returns.

The Financial News recently published an article about the world’s most profitable hedge funds. (The ranking, conducted by Bloomberg Magazine, appeared in the February 2012 issue.) According to the Financial News article, only 26% of the top 100 hedge funds outperformed a Bloomberg index of U.S. Treasury notes, which returned 8.5% in 2011. The return on the average hedge fund from January to October 2011 was a negative 2.8%. In a recent Wall Street Journal article, Steve Eder talks about what a difficult year 2011 was for hedge funds. He cites an estimate by Hedge Fund Research that the average hedge fund lost 5% in 2011, while the S&P 500 Index gained 2.1%. That’s the third straight year that the S&P 500 has outperformed hedge funds.

This makes me wonder, What was the “real” performance of hedge funds in 2011? By the way, Bloomberg Businessweek reports that hedge funds may attract $80 billion in 2012, which makes me wonder, Have these investors read any of these studies?


* For those of you who are not baseball fans, this statement was allegedly uttered by a young baseball fan after Shoeless Joe Jackson admitted in court that he accepted bribes to throw the 1919 World Series in the Black Sox Scandal.

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

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