According to a new study on alternative investing produced by risk management firm Riskdata, 30% of highly illiquid hedge fund strategies are taking advantage of the impossibility of obtaining objective net asset value figures. Take Bear Stearns. When Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage hedge fund posted an 18.97% decline in April, investors were taken aback. Up to that point, the fund had seemed to be performing somewhat averagely, but there was little to indicate that huge swings in performance were on the horizon. In the first four months of its existence, the fund posted a cumulative 4.44% return. Up to April, the fund was then down 4%, and even in April Bear Stearns said it was expecting a loss of 6.5% for the month – nowhere near the almost 19% loss it then revised this figure to.
The reason for such a dramatic change in returns reported to investors seems likely to be that the fund was "smoothing" its returns. For hedge funds operating highly illiquid strategies, pricing has to be done by asking a handful of brokers for quotes – and these often vary by several percentage points. It can be tempting, therefore, to choose a NAV quote from a broker that appeals best to the end investor, and essentially keeps the return profile of the fund from jumping significantly in either direction.
Riskdata released its study in July of more than 1,000 hedge funds and attempted to uncover how much smoothing is done by various strategies.
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Smoothing returns from selective nav |
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Bias ratio median and 68% confidence interval |
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Source: Riskdata |
The results demonstrated that illiquid strategies are most prone to this effect, and in particular funds dealing in asset-backed and mortgage-backed securities. More than 30% of the funds trading illiquid strategies were shown to be smoothing returns. Olivier Le Marois, CEO of Riskdata, says that such smoothing, although not fraudulent, is unfair, and that both managers and investors need to take responsibility for ensuring that it is stopped.
Objectivity is penalized
He says: "It is creating unfair competition for managers using an objective valuations approach either because they are trading liquid securities or using third-party data, while those using a subjective process of valuation can bias their performance pattern. If you have investors who are driven solely by ex-post performance indicators, such as the Sharpe ratio or number of positive months, it is far too tempting for managers to smooth returns, and it is the people following an objective process of valuation who are penalized."
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"Investors in funds that are applying this smoothing process are not getting the full picture in terms of risk"
Olivier Le Marois, Riskdata |
Le Marois also points out the risk to investors themselves.
"Investors in funds that are applying this smoothing process are not getting the full picture in terms of risk," he says. It is their responsibility to double-check what their manager is doing through risk control solutions and through due diligence of the fund valuation process."
One head of a multi-billion fund of hedge funds in Europe says he did not invest in the Bear Stearns fund, as his firm refuses to invest with strategies that are not marking to market.
The action of smoothing is far from a widespread phenomenon in the hedge fund industry, especially given that the majority of managers are trading in liquid securities. Le Marois suggests, however, that while there is not a systemic risk arising from smoothing, there is reputational risk for the industry. "It’s only 1% or 2% of hedge funds, but it could end up with investors becoming untrusting of a larger percentage of managers," he says.