Mon, November 09, 2009

One Out of Five Hedge Funds Is Lying

In my first year of practice, a client asked me what I thought of hedge funds.  I remember replying that my main concern about hedge funds is that most of them are “black boxes:” it’s difficult, if not impossible, to know what you’re buying when you invest in one. 

In catching up on my reading last week, I ran across a mention in Alan Abelson’s Barron’s column of a paper entitled Trust and Delegation by a group of faculty from NYU, Yale, UMass-Amherst and UC-Irvine.  In the wake of the Madoff scandal, the authors decided to scrutinize the accuracy of information provided by hedge fund managers.  I was intrigued to find that it provides evidence that some of my reservations about hedge funds are justified.  Not only do you not know what you’re getting, but even if you inquire, you may not be told the truth.

Information on the inner workings of most hedge funds is closely guarded, but there are third-party firms that can be hired to act as verifiers of hedge fund particulars.  The authors looked at “due diligence” reports for 444 hedge funds to see how often their managers were found to be deviating from the truth.  The paper divides managers into two groups:  “strategic liars,” who disclosed some (but not all) issues that should have been reported, and garden-variety “liars,” who failed to disclose any problems even though they existed. 

The authors found that in 21% of the funds, managers misrepresented past problems or background information.  They also concluded that “20% of managers interviewed had poor recollection about basic levels of assets and performance.  For example, one manager’s verbal assets under management figure were [sic] over $300 million higher than the actual number.”

They also concluded that funds whose asset prices were determined internally tended to have better reported performance than funds whose assets were priced independently; this suggests that funds without independent pricing may be manipulating their performance in some way.  Hedge funds that didn’t use major auditing firms seemed to report higher performance, too: “While funds without Big 4 auditors may indeed be better performers, an alternative explanation for these findings is that the returns reported by firms without Big 4 auditors may not be trustworthy.”

The paper also noted that:

In part because the SEC does not allow hedge funds to engage in general solicitation, they have historically relied on trusted referrals as a prime distribution channel. This reliance on referrals, and the limited transparency with respect to performance and operations, are potential reasons why the Madoff scheme could last so long. Relatively few third party entities had access to performance statistics, information about firm auditors, pricing policies, self-administration and custody.

In other words, the people who provide referrals to hedge funds often don’t possess accurate information about the funds (hmmm, this sounds vaguely familiar....).  Clearly, having independent verification of a hedge fund’s claims is vital.  20% is not a majority, but it’s a decent chunk of the hedge fund universe.