The blog All About Alpha does a good job of alerting its readership to some of the games that hedge funds play.
A current post discusses what it calls “the mystery of slightly positive returns.” No one likes losing money, and one of the statistics that hedge funds tout in their marketing is the number of up months versus down months.
This chart showing the distribution of returns comes from a paper by Nicolas Bollen of Vanderbilt and Veronika Pool of Indiana University, and you can see that the results are more than a bit skewed:
As All About Alpha reported, “In fact, the study found that up to 10% of fund returns in one major database are statistically ‘distorted’.”
The authors found that this pattern is absent when fund managers have little latitude:
The discontinuity is absent in the three months culminating in an audit, funds that invest in liquid assets, and hedge fund risk factors, suggesting that it is generated neither by the skill of managers to avoid losses nor by nonlinearities in hedge fund asset returns. A remaining explanation is that hedge fund managers avoid reporting losses to attract and retain investors.
All About Alpha points out that the gaming isn’t limited to up versus down months:
According to the study, hedge fund managers also seem to have smoother returns when they are performing poorly. Researchers conjecture that this is because managers have an ability to “manage earnings” and are more likely to do so when their returns stink. That way, at least they can reduce volatility and goose their Sharpe ratio even if returns are lackluster.
It appears that such shenanigans are more likely in strategies where the manager has a larger degree of influence over valuations (e.g. distressed) than in strategies where valuations are marked to market (e.g. market neutral equity). This phenomenon was also found to be prevalent among managers with more than one fund – suggesting to the authors that some managers could take advantage of crossing trades between accounts to give one fund a small, but much needed boost into positive territory.
