Analysis of Over 4,200 Hedge Funds Shows “Purposeful Avoidance of Reporting Losses” and Possible Need for Regulatory Oversight
NASHVILLE, October 24, 2007 – Significant numbers of hedge fund managers purposefully and routinely avoid reporting losses in their funds by marking up the value of their portfolios, according to new research from the Vanderbilt Owen Graduate School of Management. In the wake of the sub-prime mortgage crisis and its continuing effect on global financial markets, this analysis adds a new dimension to the ongoing debate over the need for greater hedge fund regulation, according to the study’s authors.
After an in-depth analysis of more than 4,200 hedge funds, the researchers found a significant number of distortions – nearly ten percent – in the returns of hedge funds, 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. 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, according to the researchers, point toward purposeful avoidance of reporting losses, especially among funds invested in illiquid securities.
“This type of manipulation could result in investors underestimating the potential for future losses or overestimating the performance of hedge fund managers. Perhaps even more worrisome, this manipulation could be indicative of even more serious violations of an adviser’s fiduciary responsibility,” Bollen said.
Using data from the Center for International Securities and Derivatives Markets (CISDM), Owen Professor Nicolas P.B. Bollen, with Veronika K. Pool of Indiana University’s Kelley School of Business, analyzed more than 215,000 hedge fund return observations from 1994 to 2005. Among other criteria, Bollen and Pool assessed the data against a set of ten factors indicative of the trading strategies employed by hedge fund managers, including individual performance attributes such as returns on portfolios and trend indicators such as short-term interest rates, stock indexes or the change in the yield of a ten-year Treasury note.
Greater investor scrutiny, regulation needed
Bollen believes hedge fund investors should question the accuracy of fund returns and be cautious when using the number of positive returns as a metric for fund performance. Furthermore, if returns are distorted, subscriptions to or redemptions from a hedge fund may be processed with error. “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, but investors who deposit capital – which would be the more usual response in such a situation – would likely suffer,” he said.
Given that most hedge funds are not registered with the Securities and Exchange Commission and are audited less frequently than other types of investment vehicles, the research also debunks the argument that historically low numbers of fraud cases prosecuted by the SEC means that additional oversight is unwarranted. “Regulators may find the robust discontinuity we document indicative of much more widespread violations and worthy of their attention,” the researchers said.
The study, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution,” is available for download through the Social Science Research Network (SSRN).
Vanderbilt Owen School of Management is ranked as a top institution by BusinessWeek, The Wall Street Journal, U.S. News & World Report, Financial Times and Forbes. For more information about Owen, visit www.owen.vanderbilt.edu.
