Are Hedge Fund Managers Systematically Misreporting? Or Not?

The following post comes to us from Philippe Jorion and Christopher Schwarz, both of the Finance Area at the University of California at Irvine.

The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.

In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.

In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.

Adjusting for this effect, we find that Long-Short Equity hedge funds, which are largely unaffected by asset illiquidity, have no kink in their gross return distribution. This contrasts with their net return distribution, which displays a statistically significant kink. For other less liquid styles, the distributions of gross returns still have kinks, albeit significantly smaller than in the net return distributions. These remaining kinks seem to be an artifact of the zero boundary for yields on fixed-income assets as well as other properties of the securities held in their portfolios. To demonstrate that the return patterns of hedge funds’ underlying securities can cause distribution discontinuities, we show that the return distribution of non-equity mutual funds, where prices cannot be manipulated, also has a large kink at zero. Finally, we also show a large portion of the variation in the remaining gross distribution kink sizes across hedge fund styles can be explained simply by variation in asset illiquidity.

In summary, we report plausible non-manipulation explanations for the observed discontinuities in the distributions of the net returns of hedge funds. These include the effect of the incentive fee accrual process, the boundary at zero for fixed income yields, and the impact of asset illiquidity. As a result, these discontinuities cannot be taken as direct evidence that hedge fund managers misreport returns.

The full paper is available for download here.

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