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| Prof. Nicolas Bollen |
Hedge Funds in recent years have been the sexiest area of finance. Managers have been able to get a 20% cut of profits - the stars can command more than 40% in addition to annual fees.
Top 25 hedge fund earners raked in more than $14 billion in fees in 2006 - equivalent to the GDP of Jordan or Uruguay. Ph.D and mathematician James Simons' $6 billion Medallion easily exceeded its roughly 36% average annualized net return since he launched the quant-based fund in 1988. Simons charges a hefty 5 percent management fee and 44 percent performance fee.
Beyond the so-called stars, the hedge fund business is becoming crowded and in August, the month when the global credit crunch took hold, hedge fund returns failed to match the rise of the Standard & Poor's Index and Dow Industrial Average, on the New York Stock Exchange. Simply, some of the perceived Masters of the Universe have lost their lustre. (See: Hedge Fund Managers, Cold Sweats and Soothing Words from a Psychologist).
Hedge-fund adviser Hennessee Group LLC reported on Monday that its hedge-fund index advanced 2.26% in September after 0.72% decline in August. The index is up more than 10% for the year through the end of September, compared with an 11.5% advance for the Dow Jones Industrial Average and a 7.7% rise for the Standard & Poor's 500-stock index.
Besides real results, there is increasing evidence of massaging performance figures, a serious issue in these turbulent times, given what's at stake. One study published this year showed that average hedge fund returns during December are significantly higher than those during the rest of the year and today, the Wall Street Journal reports on recent academic evidence of gaming the market.
On Monday, the Financial Times reported that investors will withdraw $500bn (£245bn, €355bn) - a quarter of the asset base - from hedge funds in the next year, leading to the collapse of a "large number" of hedge funds.
So predicts Giles Conway-Gordon, managing partner of Cogo Wolf, a San Francisco-based fund of hedge funds, who believes investors are increasingly dissatisfied with industry performance, and that computer-driven quantitative hedge funds now simply run too much money to make healthy returns.
"I don't think it [the hedge fund industry] can support $2,000bn of assets. I think we are going to see large numbers of hedge funds go out of business, and rightly so," he told the FT. "Hedge funds are supposed to avoid losses when things are bad, but there are very few that can break even then. I think a lot of them are not earning their keep."
"There's a hell of a wave of money, say $500bn, coming out of hedge funds over the next year. There is going to be more of a focus on demonstrable results and track records that do not rely on 10-12 times leverage.
"I think we are going to see a very sharp Darwinian process in the next six months. Things have been too easy for too long and I think cold winds are about to blow." FT article.
The Wall Street Journal reports that new academic research suggests that some hedge-fund managers may cherry-pick flattering prices when valuing securities that don't actively trade, in an effort to improve the performance of their funds.
The Journal says that investors should take heed because this massaging can help make the difference between a winning or losing month, the research found. For hedge-fund managers, such statistics on the number of winning and losing months have grown increasingly significant as the number of hedge funds has exploded -- to more than 7,500 -- and managers vie to attract and retain investor capital.
The academic research found a significant difference in the number of funds reporting a slight gain compared with a slight loss in any given month. That difference was most pronounced for funds that trade illiquid securities; it didn't show up in funds that primarily trade stocks or futures contracts, which have active markets and easily obtained prices. This suggests that some funds could be fudging results.
In a paper (download from bottom of linked page) published on October 1st, Nicolas P.B. Bollen, an associate finance professor at Vanderbilt University, and Veronika K. Pool, an assistant finance professor at Indiana University write: "We find a significant discontinuity in the pooled distribution of reported hedge fund returns: the number of small gains far exceeds the number of small losses. The discontinuity is present in live funds, defunct funds, and funds of all ages, suggesting that it is not caused by database biases. 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."
The study used a hedge-fund database from the University of Massachusetts to analyze monthly returns from 4,268 hedge funds with varying investment styles from 1994 to 2005.
"Some managers might be purposely marking up their portfolios to hide unrealized losses. Alternatively, managers might simply be prone to overvalue their own securities, perhaps in the same way that retail investors have been shown to be overconfident in their abilities to pick winners...We leave additional study of this behavioral explanation for future research.
If some managers are in fact purposely avoiding reporting losses, then investors may underestimate the potential for losses in the future and may overestimate the ability of hedge fund managers," Bollen and Pool conclude.
In a paper titled: Why is Santa so kind to hedge funds? The December return puzzle!, published in March 2007, the authors write: "that the average hedge fund returns during December are significantly higher than those during the rest of the year. This December spike cannot be fully explained by increase in the funds� risk exposures or by higher factor risk premiums in December. We argue that hedge fund contractual features provide incentives to inflate returns at year-end. Consistent with this notion, we find that the spike is indeed more pronounced among funds with in-the-money managerial options, higher pay-performance sensitivities, better relative performance compared to its peers, higher dollar management fees, and lower lockup periods. In addition to incentives, we find that the spike is higher for funds with greater opportunities to manage returns (i.e., those with higher volatility and higher exposure to liquidity risk). Finally, we demonstrate that funds engage in returns management by under-reporting returns earlier in the year and/or by borrowing from January returns in the following year."
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Finfacts report April 2006: Research shows that hedge funds produce poor returns in long-term; Performance data subject to manipulation
