Hedge funds come unstuck on truth-twisting

Date: Wednesday, April 9, 2008
Author: Matthew Lynn, The Sydney Morning Herald

Commentary by Matthew Lynn

Has the hedge-fund industry been built on a series of lies?

For the past decade, its explosive growth has been based on a simple claim: that skilled money managers, motivated by high performance fees, could outperform the market when it was going up - and sidestep the trouble when it was going down.

And yet the credit crunch has shown that to be a myth. Although a few hedge-fund managers have done brilliantly, far more have come unstuck.

Now it looks as if the industry might be based on a more systematic falsehood. Two recent academic studies suggest that hedge funds have been routinely dishonest, or at least economical with the truth.

If that's right, then it is worrying for alternative-asset managers. As the idea gets out that hedge funds can't deliver the kind of guaranteed returns they promised, a lot of money is heading for the door marked exit.

There is no questioning the gloom surrounding a once-booming industry. Almost every day brings news of another fund stumbling. More than a dozen big hedge funds have shut up shop, frozen redemptions or been forced to find outside capital this year as markets turned volatile.

Peloton Partners liquidated its largest fund after making bets on mortgage securities that turned sour, while JWM Partners, run by former Long-Term Capital Management chief John Meriwether, was hurt by swings in Japanese government bonds. Overall, hedge funds turned in their worse quarterly performance in six years, according to Chicago-based Hedge Fund Research.

Distorted Returns

Everyone knows that the markets go down as well as up. There isn't any investment that makes money every year. The hedge funds were bound to go through a bad patch. But what if the funds have been distorting the truth?

Veronika Krepely Pool, assistant professor of finance at Indiana University in Bloomington, Indiana, and Nicolas Bollen, associate professor of finance at Vanderbilt University in Nashville, Tennessee, examined how hedge funds reported to their investors over several years. Although the funds often scored a gain of 1% a month, they rarely reported a loss of the same amount.

''We estimate that approximately 10% of returns in the database we use are distorted,'' they concluded. ''This suggests that misreporting returns is a widespread phenomenon.''

Of course, you can understand why that might be happening. It's embarrassing to own up to losing money when you have promised investors you will make a profit. The difference between losing 0.1% and making 0.1% might not add up to much in money terms. Yet in terms of presentation it can be crucial. You might excuse that as a small lie. The trouble with small lies, however, is that they lead to bigger ones.

'Outright Con Artists'

A report from Wharton School of the University of Pennsylvania suggests dishonesty on a greater scale. Statistics Professor Dean Foster and Brookings Institution Senior Fellow H. Peyton Young said it is easy for hedge funds to start up and make money without having any real investment skills.

''It is very hard to set up an incentive structure that rewards skilled hedge-fund managers without at the same time rewarding unskilled managers and outright con artists,'' they said in a paper called ''The Hedge Fund Game.''

So how is it done? They say you can just replicate an investment strategy devised elsewhere, take big positions, and collect enormous performance fees until the whole thing blows up. By then, you will already have pocketed plenty of money, and you won't have to pay any of it back if the fund goes bust.

''It is extremely difficult to detect, from a fund's track record, whether a manager is actually able to deliver excess returns, is merely lucky, or is an outright con artist,'' they said.

Raw Deal

There is nothing about those conclusions that will surprise anyone who has followed the hedge-fund industry. The deal was that in return for high fees, which in effect gave the managers a stake in the fund, investors would get above-average returns.

Yet, it appears many funds have just been relying on a rising market and sitting back and collecting 20% - the typical performance fee on a hedge fund - of the profits.

The conclusion? The promise on which the industry was built looks to be largely a false one.

If investors start to question the hedge funds' ability to produce consistently superior returns, they will start to exit the industry in droves - and rightly so.

The hedge funds need to start tightening up their reporting procedures. Massaging your results to make your performance look better isn't acceptable.

More important, they need to re-examine their strategies to see if they are genuinely beating the market - because if they aren't, they should hand their money back to investors.