The Reliability of Voluntary Disclosures: Evidence from Hedge Funds

In the paper, The Reliability of Voluntary Disclosures: Evidence from Hedge Funds, which was recently made publicly available on SSRN, we examine the reliability of these voluntary disclosures by hedge funds, by tracking changes to statements of performance in the publicly available hedge fund databases recorded at different points in time between 2007 and 2011. In each vintage of these databases, hedge funds provide information on their performance from the time they began reporting to the database until the most recent period. We find evidence that in successive vintages of these databases, older performance records (pertaining to periods as far back as fifteen years) of hedge funds are routinely revised. This behavior is widespread: nearly 40% of the 18,382 hedge funds in our sample have revised their previous returns by at least 0.01% at least once, and over 20% of funds have revised a previous monthly return by at least 0.5%. While positive revisions are also commonplace, negative revisions are more likely and larger when they occur, i.e., on average, initially provided returns present a rosier picture of hedge fund performance than finally revised performance. Moreover, these revisions are not random. Indeed, we employ information on the characteristics and past performance of hedge funds to predict them. For example, funds in the Emerging Markets style are significantly more likely to have revised their histories of returns than Fixed Income funds, and larger funds, more volatile funds, and less liquid funds are all more likely to revise.

To provide an example of the sort of episode to which we refer, consider the (anonymized but true) case of Hedge Fund X, which was incorporated in the early 1990s. Four months later the fund began reporting to a database and a year after inception, it reported assets under management (AUM) in the top quintile of all funds. In the mid-2000s, the fund experienced a troubled quarter and saw its AUM halve in value. It then ceased reporting AUM figures. The fund’s performance recovered, and during the last quarter of 2008 it reported a particularly good double digit return, putting it in the top decile of funds. However a few months later this high return was revised downward significantly, into a large negative return. A similar pattern emerged later that year, when a previously reported high month return was substantially adjusted downward in a later vintage, along with two other past returns altered. A further sequence of poor returns was then revealed, and the fund was finally reported as closed in 2009.

The example provided above suggests that these revisions should be interpreted as negative signals by investors, that is, that they are manifestations of the asymmetric information problem embedded in voluntary disclosures of financial information. However, it is entirely possible that revisions are innocuous despite being systematically associated with particular fund characteristics. For example, they may simply be corrections of earlier mistakes, and therefore contain no information about future fund performance. To better understand the information content of revisions, at each vintage of data we categorize hedge funds into those that have revised their return histories at least once (revisers) and the remainder (non-revisers). We find that, on average, revising funds significantly underperform non-revising funds, and there is a far greater risk of experiencing a large negative return when investing in a revising fund. In short, this method reveals in real time that funds with unreliable reported returns are likely to underperform in the future. The finding is virtually unchanged by risk-adjustment using various models, not greatly affected by varying the threshold for detecting significant revisions, stronger for revisions pertaining to periods far back in time, stronger for funds with higher levels of asset illiquidity, and robust to various other changes in parameter values. The results from these robustness checks also provide evidence that performance differentials are higher for more illiquid funds, but that they are not merely reflections of more accurate subsequent data on historical values of illiquid securities held by funds.

Our analysis suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC earlier this year, could be beneficial to investors and not just regulators. Two links with the issue of information disclosure in health economics are noteworthy. Jin and Leslie (2003) use the 1998 implementation of a rule that restaurants in Los Angeles prominently display standardized hygiene “grade” cards to study this issue. They find that the increase in the information provided to consumers made them more sensitive to hygiene scores, and caused them to substitute away from low to high hygiene establishments, thus raising overall hygiene levels across all restaurants. To draw a parallel with our hedge fund application, the mandatory and timely provision of accurate performance data may enable investors to better distinguish between high and low skill funds, thus generating significant welfare improvements by raising quality standards for investment management.

An alternative perspective considers the appropriate form of the mandated disclosure. Dranove, et al. (2003) analyze the use of publicly available “report cards” (which measure not only health outcomes, but also the initial health of patients) on individual doctors and hospitals in New York and Pennsylvania in the early 1990s. These were introduced with the aim of enabling patients to identify the best health care providers, and to provide an incentive for these health care providers to improve the quality of care offered. However, the authors find that report cards lead to more surgeries for healthier patients, where the gains are lower and the costs the same, and the substitution of less invasive procedures in place of surgeries for sicker patients, leading to worse health outcomes. This suggests that health care providers acquire “inside information” on the patient’s initial health after having seen them, and may decline to treat patients that are riskier in person than on paper, as this would lead to a low report card score. This evidence raises questions about the potential impacts of mandatory hedge fund disclosures. Assume that hedge funds are more highly skilled at valuing illiquid assets than regulators, who establish standardized valuation methods for mandatory disclosures. Then standardization may lead to funds avoiding assets that they deem to be under-valued relative to the standardized valuation method, even if these are in reality worthwhile investments. This substitution away from such illiquid assets could in turn lead to lower liquidity and efficiency of these asset markets.

A solution might be to design a disclosure system that allows funds some flexibility in the choice of valuation method used to report performance, despite the presence of a standard method. The presence of a standardized, transparent method for valuing illiquid assets in hedge fund portfolios may make investors more sensitive to the use of other valuation methods, and may increase the overall quality of pricing such assets, but with exemptions provided if requested and justified. For example, a hedge fund may have a good reason to decide to price an illiquid asset using a non-standard method, and if the standard method is well-known and understood, then the reasons for using a different approach would need to be made clear to investors. Thus a standard approach may provide a lower bound on the quality of method for pricing an illiquid asset.

The full paper is available for download here.