Swedroe: Revisionary Hedge Fund History

There are a number of well-known biases in the reported returns of hedge funds. Among them are survivorship bias (estimated to be about 3 to 4 percent) and backfill, or “instant history,” bias (estimated at more than 5 percent per year).

There’s also the issue of self-selection, or self-reporting, bias. Poorly performing funds may choose not to report, although some funds that have performed well may also choose not to report because they may be closed to new investors and thus don’t need to attract new assets.

Self-reporting also leads to situations in which it’s possible that different models are used to value assets, as well as the potential for earnings smoothing, understating the true volatility of returns and making assets appear to be less correlated with other assets than they truly are. Indeed, researchers have found that smoother returns are associated with managers who possess greater discretion in sourcing the prices used to value the fund’s investment positions.

There’s yet another large and important bias in the data—liquidation bias. This phenomenon occurs because funds that become defunct frequently fail to report their last returns. One study estimated that this effect resulted in a bias that overestimates returns by 3 percent to as much as 6 percent.

Data Revisions Study

If all these problems weren’t already enough, Andrew Patton, Tarun Ramadorai and Michael Streatfield—authors of the study “Change You Can Believe In? Hedge Fund Data Revisions,” which appears in the June 2015 issue of the Journal of Finance—supply investors with another concern related to the reported historical performance of hedge funds.

Their study covered the period July 2007 through May 2011 and more than 12,000 hedge funds. Following is a summary of the authors’ findings:

• In successive vintages of databases, older performance records—pertaining to periods as far back as 15 years—are routinely revised.
• While positive revisions are commonplace, negative revisions are more common and larger when they occur. On average, initially provided returns present a rosier picture of hedge fund performance than finally revised returns. This may suggest prospective investors face the danger of being wooed into making decisions based on initially reported histories, which are then subsequently revised.
• Almost 50 percent of hedge funds (which accounted for almost 50 percent of assets under management in the hedge fund universe) revised their previous returns at least once. Nearly 30 percent of hedge funds revised a previous monthly return by at least 0.5 percent, and more than 20 percent of hedge funds revised a previous monthly return by at least 1 percent.
• Importantly, almost one half of the return revisions were to returns more than 12 months in the past, making it unlikely that these revisions are merely corrections of data entry errors, or a simple consequence of illiquid positions being marked-to-market.
• Larger funds, more volatile funds and less liquid funds were more likely to revise. However, smaller funds, and those with high incentive fees, have larger revisions.
• A fund experiencing a change in management company or manager is 10 percent more likely to revise its past returns, holding all else constant. New management might be interested in a fresh start, revamping the accounting, marking-to-market, auditing and compliance practices of their newly acquired funds, which in turn triggers a set of revisions to past returns.
• Funds with a high-water mark are 13 percent more likely to revise than funds without a high-water mark. Managers have greater incentives to revise past returns downward when they are well below their high-water marks, resetting levels at which they begin earning performance fees. When funds with a high-water mark revise returns, their average return revision is 62 basis points.
• Offshore funds have larger absolute revisions. Potentially weaker enforcement in such jurisdictions may lead to more important revisions.
• The performance differentials between revisers and nonrevisers were higher for more illiquid funds, but weren’t restricted to these funds. In addition, revisers experienced a much higher liquidation rate than nonrevisers.
• Simple errors such as digit transpositions and decimal point errors made up only a negligible fraction of the revisions observed.
• Detecting that a hedge fund has revised one of its past returns helps predict that it will subsequently underperform funds that have never revised their returns, and increases the probability that the fund will cease reporting to a database, potentially due to liquidation.
• Perhaps surprisingly, hedge funds with audit information appear to be associated with revisions that are larger in absolute value, suggesting that at least some revisions may be occasioned by the enhanced scrutiny generated by recent audits or the appointment of a new auditor. This is consistent with prior research, which has found that funds with prominent auditors have more misreporting discontinuities.

The authors concluded: “Our analysis suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC in 2011, could be beneficial to investors and not just regulators, and contributes to a growing list of examples highlighting the benefits of an independent auditor or regulator for financial institutions.”

They added these cautionary words: “The significantly lower future returns and greater downside risks in troubled times experienced by funds with unreliable disclosures suggests that the issue that we identify represents a source of risk to hedge fund investors, and quite possibly a broader systemic risk.”

In addition to the very poor returns that hedge fund investors have experienced over the past 10 years (the HFRX Global Hedge Fund Index returned just 0.7 percent a year from 2005 through 2014), Patton, Ramadorai and Streatfield provide us with one more reason to avoid investing in them: a lack of ability to trust reported returns.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.