Routine Inflation of Hedge Fund Returns

Wide Discretion in Valuing Illiquid Securities Results in Misreported Returns, Inflated Portfolio Values

bollen_1High-profile implosions in the hedge fund market and economic turmoil stemming from the sub-prime mortgage crisis have not diminished the love affair between investors and hedge funds. This is understandable, given that hedge funds reportedly ended 2007 with an average 10 percent return,  and investors have been so thrilled by this performance that they pumped $21.8 billion into hedge fund coffers in November alone.

RIGHT: Nick Bollen, E. Bronson Ingram Professor of Finance

However, there has always been some ambiguity about hedge fund performance since most hedge funds are not registered with the Securities and Exchange Commission (SEC) and are audited less frequently than other types of investment vehicles. In these days of market turbulence, with the economic forecast growing murkier, it is therefore prudent to ask what kind of value this booming, $1.3 trillion industry is really bringing to investor portfolios—and what kind of risks it is presenting to the financial markets.


High-profile fund implosions and continued economic turmoil from the sub-prime mortgage crisis have not diminished the love affair between investors and hedge funds. But new research by Nick Bollen, E. Bronson Ingram Professor in Finance, discovered that a significant number of hedge fund managers routinely and purposefully avoid reporting losses in their funds by marking up the value of their portfolios.

Such was the intent of Nick Bollen, E. Bronson Ingram Professor in Finance at Vanderbilt Owen Graduate School of Management, when he embarked on research to determine how reliable the reported returns from hedge funds really are. As it turned out, in a comprehensive analysis of returns over an 11-year period, he discovered disturbing disparities that could add to the dyspepsia investors are experiencing in other financial markets and could prompt a closer look at hedge funds by Washington regulators.

Manipulated returns, inflated portfolio values

In partnership with Veronika K. Pool of Indiana University’s Kelley School of Business, Bollen conducted an analysis of more than 4,200 hedge funds and discovered that a significant number of hedge fund managers routinely avoid reporting losses in their funds by marking up the value of their portfolios. Using data from the Center for International Securities and Derivatives Markets (CISDM), more than 215,000 monthly hedge fund returns from 1994 to 2005 were analyzed against a set of ten factors indicative of the trading strategies employed by hedge fund managers. These factors included individual performance attributes and trend indicators such as short-term interest rates or the change in the yield of a ten-year Treasury note.

Bollen found a significant number of these hedge fund returns—nearly 10 percent—were distorted, but that 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. More specifically, funds tended to report small monthly gains more frequently than small monthly losses, suggesting that hedge fund managers sometimes round up returns to make sure they are slightly positive.

Purposeful Avoidance of Reporting Losses

The study’s results, according to Bollen, point toward purposeful avoidance of reporting losses, especially among funds invested in illiquid securities, such as mortgage-backed securities.

Part of the problem, Bollen speculates, is the high amount of discretion that fund managers have in valuing illiquid investments. Managers can use internal models to establish asset values, or they can pick and choose from a wide array of quoted prices from brokers. This ambiguous approach to valuation has, in turn, a substantial impact on whether funds report losses or gains in their overall portfolios. The implosion of two major hedge funds within financial giant Bear Stearns in 2007 propelled this issue to the forefront, given that the firm’s valuations of illiquid securities were adjusted in reports to investors.

According to Bollen, the relationship between the misreporting of returns documented in his research and the fact that the markets for illiquid securities—such as those backed by mortgages—are in turmoil has become crucial in the current, unstable environment. “A major argument for the value of hedge funds is their ability to deploy capital in creative ways and bring more liquidity to relatively illiquid markets,” said Bollen. “But as we’ve seen in the sub-prime mortgage fallout, the benefits of this increased market liquidity need to be tempered by a better understanding of the risks involved and more consistency regarding what these investments are actually worth.”

Better assessment, possibly regulatory oversight

Bollen believes that the manipulation his study documents “could result in investors underestimating the potential for future losses or overestimating the performance of hedge fund managers.” Perhaps more worrisome is that this manipulation could be indicative of even more serious violations of an adviser’s fiduciary responsibility. “Regulators may find the robust discontinuity the study documented to be indicative of much more widespread violations,” said Bollen.

According to Bollen, investors should question the accuracy of fund returns and be cautious when using positive returns as a metric for 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. However, inflated returns would likely motivate investors to keep their capital parked in a fund—exposing them to potential losses longer-term,” he said.

The current environment also has many industry analysts and experts asking whether better disclosure or stronger regulations might help to stave off future hedge fund collapses. New regulations proposed recently by the SEC that would require hedge fund managers to register as investment advisors ended up being struck down in court. But even if tighter regulation is not in store, Bollen believes that a series of SEC-issued “best practices”—along with support from some big institutional investors—would create a market incentive to encourage adherence and result in greater disclosure from hedge funds and more consistency in reporting and valuation.

“In the end, a more diligent and transparent approach would benefit hedge funds as well as investors,” sa