Harold Bradley: Hedge fund lies, darned lies and statistics...

Date: Monday, February 23, 2009
Author: Economy. Kansascity.com

It’s all over the media. Hedge funds didn’t do their job in 2008. A group called Hedge Fund Research (HFR) publishes performance data on hedge funds and funds of hedge funds. Consultants have been gushing for years over the magic elixir provided by really smart and creative money managers, whose very existence would be compromised, if not extinguished, by providing transparency into their methods and madness.

Consultants made mountains of money recommending hedge fund of funds to high net worth investors, small endowments and foundations – because it’s what the big foundations and endowments do.

Last year, individual hedge funds and funds of hedge funds lost a lot of money. We think they lost a lot more than any of the widely reported news stories suggest.

You see, as private partnerships for investors who should know that they might lose it all, hedge funds are prohibited by the SEC from advertising performance. The SEC historically worried that such advertising might attract the “wrong” investors into this category – a little like the new hanging insect detectors that use octenol to lure mosquitoes into the sizzle that ends their lives.

Hedge funds are approved only for those who have a net worth of $2.5 million or have earned more than $250,000 in each of the past two years.

Investors in hedge funds sign agreements to not reveal portfolio returns. HFR entered the fray and many hedge funds provide return data “voluntarily” to the HFR group, who in turn sells the data to consultants and institutions to better monitor industry trends.

The long term data on returns and volatility still indicate that hedge funds, despite high fees and profit participation, deliver returns similar or better than equities with less dramatic swings in value. At least that’s true according to the data that we can see. But can we trust it?

A 2007 article in the Journal of Portfolio Management asked “Why Do Hedge Funds Stop Reporting Performance?” Well respected finance academics examined what is called “survivorship bias.” In other words, they tried to figure out how many funds volunteer not to report really bad performance.

The authors suspect that over the long term, annualized returns might be 3.0% worse in real life than reported in the “voluntary” indexes and represented with certainty by consultants.

One of the first reforms Mary Shapiro should make at the SEC, now that Alan Greenspan is no longer in place to defy regulation of hedge funds, is to make all hedge funds consistently report performance as long as they remain in business. I would urge the same for consultants, but that’s another column.

Investors, even those considered “sophisticated,” fly blind when consultants (who aren’t measured for efficacy) cite performance data from third parties who collect “voluntary” data.

At this foundation, we use hedge funds as part of our approach to portfolio management. We make sure we know how funds make investment decisions and insist on metrics and transparency. We measure our effectiveness against the HFR Index of Fund of Funds. By comparing our results to a fund of funds index, we tried to control for those who elect not to report their bad quarter or year. A hedge fund within a collection of hedge funds can’t make that election.

So imagine our surprise this year. At the peak of the hedge fund frenzy in the second quarter of 2008, there were 1560 fund of funds reporting results to HFR, the “unofficial” scorekeeper. (By the way, fund of funds managers earn extra fees on top of the high hedge fund and profit-sharing of the individual funds). At the end of last year’s carnage, only 1,066 funds of funds were still reporting results to HFR.

The average reported 2008 return for fund of funds was -20.4%. Now, it’s not much of a stretch to assume that it was the worst performing funds that chose not to report. So, realizing there might be some estimate error, let’s assume those funds that quit reporting or went out of business were worse than the ones who decided to keep going.

So, my colleague and I used the average annual return for last year for those funds in the 95th percentile of performance – -45.2%. If we assume that each of these 455 dropouts averaged that return, then the average fund of funds lost -27.0%, and not -20.4%. (Of course, a number of those funds owned a whole lot of Bernie Madoff’s Ponzi scheme and went to zero, so this might be an optimistic assessment). This is material to any investor who might care.

Until the SEC compels reporting consistency among consultants and hedge funds, then even sophisticated investors cannot grasp the uncertainty that is a given in the modern financial world.

Harold Bradley is chief investment officer at the Kauffman Foundation in Kansas City.