The Journal is breathtaking in its propensity to sell stories past their sell-by date as news.
The latest example is an article, “Pricing Tactics of Hedge Funds Under Spotlight,” that will appear in the Tuesday “Heard on the Street.” Here’s the opening paragraph:
New academic research suggests that some hedge-fund managers may cherry-pick flattering prices when valuing securities that don’t actively trade in an effort to improve the performance of their funds.
Now once in a while, academic research on the financial markets can come up with novel insights, as it did in unearthing options backdating. But for the most part, academic studies seek to test common beliefs or dig into unanswered questions.
Put it another way: it is odd indeed for the Journal to first talk about possible dubious hedge fund valuation practices via an academic study. This has been common knowledge among dealers, so one has to wonder why the Journal waited to long to take interest. Perhaps it didn’t want to raise doubts about hedge funds when the markets looked rocky? But it is at precisely those times when that sort of information is most useful.
I must admit I was exceedingly lazy in looking for evidence that this issue had been discussed earlier. I merely searched my own posts and found this quote from the Financial Times back in June:
“It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that,” says one banker who advises hedge funds. “Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture.”
Back to the Journal. The story goes on to note, quel surprise, that the hedge fund engage in this sort of behavior to boost performance.
However, caviling aside, there is some new information in the piece, namely, that funds that hold a fair number of positions in illiquid securities appear to seek out favorable valuations to turn months with negative returns into positive results:
Investors should take heed because this massaging can help make the difference between a winning or losing month, the research found…..
So far, investors, auditors and regulators have focused on the way banks and brokers value these securities. But the new research suggests hedge funds may be an even bigger area of concern.
Forgive me for interrupting. The reason regulators haven’t focused on hedge funds is they have no jurisdiction over them. Back to the article:
The academic research found a significant difference in the number of funds reporting a slight gain compared with a slight loss in any given month. That difference was most pronounced for funds that trade illiquid securities; it didn’t show up in funds that primarily trade stocks or futures contracts, which have active markets and easily obtained prices. This suggests that some funds could be fudging results.
“Hedge-fund managers purposefully avoid reporting losses by marking up the value of their portfolios,” according to the authors of the study, Nicolas P.B. Bollen, an associate finance professor at Vanderbilt University, and Veronika K. Pool, an assistant finance professor at Indiana University. If that is the case, the authors wrote, investors may “underestimate the potential for losses in the future and may overestimate the ability of hedge-fund managers.”
The study used a hedge-fund database from the University of Massachusetts to analyze monthly returns from 4,268 hedge funds with varying investment styles from 1994 to 2005….
Fund managers can have a lot of leeway in determining whether such securities have lost or gained money. As long as they remain consistent, they can, for example, choose whether to use the bid or offer price of a security, which can sometimes vary widely, or pick among different quotes offered by competing brokers. So if a hedge fund is looking at a possible loss for a month, a manager could pick the more optimistic prices for some securities to push the fund into positive territory while ignoring those that could exacerbate losses….
Previous academic research has found that a variety of hedge-fund strategies generate smoother returns than the underlying economics might justify. The recent paper by Mr. Bollen and Ms. Pool builds on this work but is different in that it suggests a manager “is going to round up returns to make sure they’re slightly positive” rather than smoothing out both gains and losses, Mr. Bollen said.
Typically, hedge-fund returns should fall along a familiar bell-curve pattern with a peak that is likely to be in slightly positive territory. That is how the returns play out for equity-neutral strategies, which bet on stocks either rising or falling in value. But that doesn’t happen for strategies that deal with illiquid securities.
“This is perhaps no surprise: Distorting returns is more feasible when the opportunity for exerting managerial discretion is higher,” the paper said.
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There is only ancillary risk to the system created by hedge funds misvaluing. The class of people being swindled (namely investors in hedge funds) are supposed to be sophisticated – if they are dumb enough to put their money into funds which can shop around in order to boost the fund manager’s performance fee, then that would seem to be their problem.
Risk to the financial system comes only when such opaque instruments are used as collateral. This is then a prime broker problem (or whoever is lending money to the hedge funds using collateral of hard-to-value instruments). If the prime brokers are accepting the word of the hedgies, then they need their heads to be examined (hopefully by the appropriate regulator).