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Much Ado About Hedge Fund Revisions

A new study showing hedge fund performance is subject to revision misses the bigger problem.

A new academic study that is gaining attention found that as many as 40 percent of around 7,000 hedge funds have revised their performance figures after reporting them to one of the handful of hedge fund databases. What’s more, the study found that funds that revise performance histories “significantly and predictably underperform” those funds that have never revised their results. But a closer look at the study shows it is much ado about very little.

The authors of the study assert that these results underscore the need for Securities and Exchange Commission’s new rule requiring U.S.-based hedge funds ­­— and other private investment funds — managing over U.S.$1.5 billion to file detailed quarterly reports using a new Form PF. (The new disclosures, however, will not be made public.)

The study was published by Professor Andrew Patton, Associate Professor of Economics at Duke University; Dr Tarun Ramadorai, from the Oxford-Man Institute of Quantitative Finance and Reader in Finance at the Saïd Business School at Oxford University, and Michael Streafield of the Saïd Business School and Oxford-Man Institute. The working paper, ‘The Reliability of Voluntary Disclosures: Evidence from Hedge Funds’, is scheduled to be presented at a conference on hedge funds at the Oxford-Man Institute of Quantitative Finance, University of Oxford, on November 18.

The study found that nearly 40 percent of the 18,382 hedge funds in its sample managing around 45 percent of average total assets revised their historical returns at least once, sometimes many years later. The average revision was at least 0.01 percent. However, more than one-fifth of the funds subsequently changed a previous monthly return by at least 0.5 percent.

More interestingly at first glance, their analysis also found that on average, funds that revise their performance histories subsequently underperform significantly, when compared with funds that have never revised their reported performance.

Oxford says in its announcement that the paper, made public this week, raises questions about the potential effects of mandatory hedge fund disclosures and considers different approaches that could be used, including a system that allows funds some flexibility in the choice of valuation method, alongside a standard method, should it be requested and justified.

“Our research highlights the unreliability of the voluntary disclosures that have hitherto been made by hedge funds on their performance track records,” says Dr. Ramadorai, in Oxford’s announcement. “The benefit of mandatory, audited disclosures of past performance to investors and regulators is that it would enable them to accurately assess the real risks and returns of hedge fund investments.”

“These revisions should be interpreted as negative signals by investors, that is, that they are manifestations of the asymmetric information problem embedded in voluntary disclosures of financial information,” the paper asserts.

One major investor in hedge funds says the study may suggest these firms suffer from sloppy back and middle offices and reflects badly on the entire firm. He also speculates that some hedge funds might be engaging in marketing spin in a rush to publish overstated performance.

“I do think it raises some interesting issues,” adds Marc E. Elovitz, a partner in the New York office of law firm Schulte Roth & Zabel.

Even so, Elovitz and other experts also believe the study’s conclusions are not as significant as they initially seem. They include the authors of the study themselves, who concede: “It is entirely possible that revisions are innocuous despite being systematically associated with particular fund characteristics.” For example, the authors add, “they may simply be corrections of earlier mistakes, and therefore contain no information about future fund performance.”

Indeed, the study itself concluded the average revision among 40 percent of the hedge funds was a mere .01 percent. “That’s not all that much to get excited about,” Elovitz stresses. This means for example, that a fund that was up, say, 12.65 percent was subsequently restated to be 12.64 percent. Rounding errors, anyone?*

And even if the fund was one of those 20 percent that revised downward by .5 *percent, that would knock down the performance to 12.15 percent. Sure, that is a little different from the original disclosure, but still not significant.

Indeed, hedge fund investors are accustomed to getting interim reports from managers complete with footnotes, preliminary estimates and warnings that these results are unaudited. Revisions are almost expected.

In fact, any long-time recipient of the databases used in the study would be right to assume that the data was off by a bit. A routine confirmation of the data with the managers themselves frequently results in a tinkering of the performance figure. But the operative word here is “tinkering.”

What’s more, it is not uncommon to see prior results change slightly as long as a year later when new versions of hedge fund directories are published.

There are a number of reasons this happens. The monthly results figures are quickly calculated and sent out shortly after the period ended. Many of the holdings are privately-held and illiquid and difficult to calculate that fast.

It is not uncommon for one hedge fund I speak with regularly to warn nearly two weeks after a quarter that the results are a rough estimate and that it has still not finished calculating the performance.

As for the suggestion that the study reinforces the need for the new Form PF, the fact is that performance has nothing to do with it. As a new report from law firm Weil, Gotshal & Manges poinyd ouy, the purpose of the new Form PF is “to assist the Financial Stability Oversight Counsel (the FSOC) in monitoring potential systemic risks to the United States financial system.”

Brad H. Alford, Chief Investment Officer of investment advisor Alpha Capital Management, says a difference of a few basis points does not matter. Rather, he is more concerned about the many side pockets stuffed with hard to value illiquid securities that were created by hedge funds a few years ago. “LP’s are stuck with these and they trade at 30 to 40 cents on dollar,” he says. “Too bad that is not in their returns. What a great way to dispose of horrible investments that will not hurt performance.”

Bottom line: The academic study focuses on the wrong hedge-fund performance issue.

*Comments from readers:

We are writing about an article that appeared in your publication on November 14 ("Much Ado About Hedge Fund Revisions"). The article discussed our research on the tendency for historical hedge fund performance figures reported to databases to be revised in later versions of these databases. While we are happy to hear others' opinions on our work, we were disappointed to see that the article contains two factual errors and one misleading statement. We would appreciate it if you would consider publishing these corrections alongside the web copy or in print as it would enable your readers to have a more accurate perspective on our work.

Factual Error #1: The article states that the paper finds that "the average revision among 40 percent of the hedge funds was a mere .01 percent". This is incorrect: the *smallest* revision we include is 0.01 percent, and the *average* revision is a hefty 0.82 percent per month.

Factual Error #2: The article states that the paper finds "as many as 40 percent of around 7,000 hedge funds have revised their performance figures". This is incorrect: approximately 40 percent of our sample of around *18,000* funds have revised their figures.

Misleading statement: The article provides an example of a reported performance figure of 12.65 percent being subsequently revised to 12.15 percent, with the accompanying suggestion that that such a difference is negligible. This is highly misleading: The 12.65 percent number employed in the article is high even for an annual performance figure, and our study looks at *monthly* performance. For an apples to apples comparison, the average monthly return across hedge funds is 0.64 percent, and a revision of 0.50 percent would almost completely wipe out this representative month's return.

The article concludes that our study is "much ado about very little". Our study shows that hedge funds revise their previously reported performance figures, and that this behavior is widespread, economically large, and useful for predicting future (poor) performance. These facts strike us as potentially very important to readers of your magazine.

Andrew Patton
Tarun Ramadorai
Michael Streatfield

Comment from author:

I should have said " least .01%"  instead of it being THE average. Of course, I feel bad about this.

Not sure why I used the number "7000" hedge funds.

But I still stand by my conclusion. I disagree with their interpretation.

My experience over the years is that virtually every fund tweaks their final number after they are audited. These changes even occur when firms submit their data for the II HF 100. I notice prior years' submitted figures changed a bit.

I spoke with several investors, at least one of whom was quoted, and they feel these changes are simply part of the process and not bothered much by them.

Stephen Taub  

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