Hedge Fund Fudging? Likely so...

Ideally, investors can trust that the value of securities they purchase is based on information that is accurately advertised and appropriately scrutinized. In the world of hedge funds investing—namely illiquid securities—the playground is complex and information is murky. Add lack of regulation to the mix, and the possibility for fraud is likely.

So says Kelley assistant professor of finance, Veronika Pool, in a new study she and Nicholas Bollen, a colleague at Vanderbuilt, conducted that captured media attention (see "Pricing Tactics of Hedge Funds Under Spotlight", Wall Street Journal, 10/9/07). Hard to price, hard to value securities has become a hot topic on Wall Street as the debt markets continue their meltdown. The study sheds light on hedge fund pricing tactics and suggests some funds inflate returns to avoid losses and attract investors.

With Merrill Lynch and Citibank leading the pack of financial giants taking multi-billion dollar write-downs of complex illiquid assets, the study is well-timed, cautioning investors that they may be paying too much. It serves as a reminder to regulators that more transparency is needed.

Hedge funds versus Mutual funds

Unlike mutual funds, hedge funds are private investments that attract a wealthy clientele. They require large minimum investments, charge high fees, operate without regulation, and use a variety of techniques to "hedge" against market downturns. However, hedge funds (and bundled funds of hedge funds) are becoming more "retailized", entering into the hands of smaller investors, as well as non-profits, universities and other institutions, so the problem extends beyond the ultra rich.

According to Pool and Bollen, the problem with valuing hedge funds is that the illiquid securities are difficult to price and fund managers have a lot of leeway in reporting performance. Unlike standard securities where fund prices can be verified on the open market, hedge funds—particularly those that don't trade often—are more difficult to value. Prices vary and the information is highly subjective. Fund managers can choose which brokers to tap for price quotes, as well as the number of quotes they include, without any specific rules or regulations they must follow to ensure consistent pricing.

Hedge funds are marketed more exclusively than mutual funds. Fund data is collected in databases that are viewed by credentialed investors (paid subscribers)—and the data had remained private until recent years. Because the databases are populated with information that managers self-report and which serves as advertisement of funds to potential investors, it's prudent to question fund performance data—a key selling factor.

Suspicious performance patterns

When the databases became more available, Pool and Bollen began examining the data for all types of funds regardless their age or status. They noticed an irregular pattern in fund performance for about 10 percent of the funds: the number of small gains far exceeded the number of small losses. At first guess, it appeared these funds had more skilled managers, since they reported a greater ratio of gains to losses. However, the pattern was not present in the three months prior to an audit† nor did it appear in funds that invested in liquid assets. So they could rule out the hedge fund managers' skill levels, as well as any nonlinearity in the asset returns.

A likely explanation was that some hedge fund managers avoid reporting losses to attract and retain investors. This type of fudging "smoothes" a return and looks more appealing to potential investors who want to see more gains than losses versus the typically jagged patterns created with numbers falling above and below zero. In this scenario investor impact is negative for those putting money into the (overvalued) fund, while the impact is positive for those withdrawing their money.

Investors, be warned

With the likelihood that some managers may be fudging their data, Pool says such patterns should be an indication to scrutinize certain funds further. She adds, "They leave footprints that raise a red flag, which can serve as a tool for investors and regulators."

To avoid fraud, investors are urged to exercise caution, and regulators are encouraged to make the information more transparent. And if the financial headlines are any indication, the impact from overpriced mortgage-related securities is far from over.

† Even though some hedge funds are registered and audited, the auditing process is not bullet-proof and lacks an established set of rules that can be applied across funds. Add to that the challenge of sorting out highly complex illiquid assets and conducting a successful audit is doubtful.