Hedge Funds Inflate December Returns

Hedge funds tend to report better than average returns in December. This isn't the greatest surprise, since they can earn massive incentive fees (typically 20% of gross profits) based on their year-end performance. As discussed in their paper "Why is Santa so kind to hedge funds? - the December return puzzle", authors Vikas Agarwal, Naveen Daniel and Narayan Naik found that this spike in December returns tends to come mainly from those managers that have the ability to inflate their returns, through favorable marking of positions, or aggressive year end trading, among many other interesting findings and interpretations.

I did some research to replicate the authors findings and sure enough, I found that by looking at index data from Hedge Fund Research [HFR], I found that December returns were by far better than average monthly returns, about 1.2% better in aggregate. From 1990-2006, the average December return for the HFR Fund of Funds Composite Index, a good benchmark for hedge funds in general, and less susceptible to survivorship and self-reporting biases that plague most hedge fund indices, was 1.94%, while the average monthly return of the previous 11 months was 0.72%. Amazingly consistent and strong year end finish for an industry! This excess was statistically significant and not driven by market conditions, but apparently to more nefarious explanations.

Some of the best year end finishers were, surprise, the Macro, Equity Hedge and Event Driven Indices, all strategies that allow managers some opportunity to artificially inflate returns. These stellar finishes apparently lead to nice beginning of year investment inflows, allowing managers to further inflate their results in January, though to a much lesser extent than December. During the remaining 10 months from Feb-Nov., monthly returns are no better or worse than others, and typically much less than December.

So hedge funds essentially manipulate their investors into thinking their performance is terrific in December, which convinces them to invest in them for the next year. Of course mutual funds play versions of this game as well, but to a much lesser, and less lucrative, extent.

Thank goodness widows and orphans aren't allowed to invest in these things - only the wealthiest and most sophisticated investors get to be conned by this chicanery and pay their outlandish fees.

Unfortunately, many non-accredited investors are indirectly exposed to this charade through pension plans, endowments, and other institutions that have flocked to hedge funds over the last several years. Performance reporting in the hedge fund world needs to be investigated and cleaned up to give it the proper legitimacy that it (maybe) deserves.