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Hedge fund valuation: Smooth returns from rough valuations

Illiquid hedge funds should stop smoothing returns, report urges.

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.

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