Over 20% Of Hedge Fund Managers Are Liars
A new study out of NYU Stern School of Business finds what many have known intuitively for years: namely that a material portion of hedge fund managers (over 20%) routinely misrepresent or outright lie about their funds and associated performance. From the Stern report (attached below):
We find that misrepresentation about past legal and regulatory problems is frequent (21%), as is incorrect or unverifiable representations about other topics (28%). Misrepresentation, the failure to use a major auditing firm and the use of internal pricing are significantly related to legal and regulatory problems, indices of operational risk.
Here is how the authors aggregated the data used in the study:
Our sample consists of 444 due diligence reports compiled by HedgeFundDueDiligence.com, a third party hedge fund due diligence service provider. These funds are managed by 403 different advisors over the period 2003 to 2008. The DD report information is gathered by the company through several channels: the offering document and marketing materials provided by the manager, on site interviews with the manager, and forms filled out by the manager. They augment this by verifying operational controls, assets under management, and performance with the administrator. Finally, they attempt to verify the authenticity of the audit with the auditor and perform a background check on the management company and its key staff.
While it should obvious why a clean sheet is critical when it comes to hedge funds, the authors provide this narrative which should be required reading of everyone at the SEC:
In part because the SEC does not allow hedge funds to engage in general solicitation, they have historically relied on trusted referrals as a prime distribution channel. This reliance on referrals, and the limited transparency with respect to performance and operations, are potential reasons why the Madoff scheme could last so long. Relatively few third party entities had access to performance statistics, information about firm auditors, pricing policies, self-administration and custody. In an environment lacking multiple, comparable sources of information about an agent’s credibility, trust is even more important, as are mechanisms to verify trustworthiness.
Some more of the in depth discoveries presented by the paper:
- We find approximately 20% of funds have managers who misrepresented past problems or their
- While funds without Big 4 auditors may indeed be better performers, an alternative explanation for
these findings is that the returns reported by firms without Big 4 auditors may not be trustworthy. Small and young funds perform better due to mangers’ desire to establish their track records while the positive coefficient on “notice period” may indicate a liquidity premium.
- Funds that strategically lie on their DD reports have higher performance than other funds after the DD report. As with the auditor result in the prior analysis, perhaps these funds are better funds. However, since these managers appear to only strategically lie to the DD company, they may also choose to “game” the return data reported to investors, which causes these funds to appear superior to their peers.
- We also find funds that have external pricing have lower performance than funds that price their own
portfolios. Non-independent pricing allows the opportunity to inflate performance through “cherry picking” of model prices or outright fraud. [not sure why this is an issue: after all the FASB has mandated major banks model their own balance sheets as they see fit, so one can likely scratch off internal pricing as a risk factor due to the administration's wholehearted endorsement of this action.]
- Artificially high performance could attract more flows from other investors, allowing such things as performance smoothing or allowing fraudulent Ponzi schemes to continue over long periods. [someone should notify the S&P about this one]
- We now find some limited evidence that transparency can lead to higher fund flow. Funds that voluntarily disclosed all of their prior problems have higher flows, and funds for which it was difficult to reconcile manager statements with other information experience lower flows. [this is one that Obama and his makeshift call for increased transparency can presumably agree with. Alas it may also explain why the volume in the market has declined precipitously over the past year.]
And the conclusion:
Some of our results were to be expected. We find that funds with legal or regulatory problems are less trustworthy. We also found that the relationship with a major auditing firm was a sufficient statistic for the tendency to tell the truth. This is particularly important as we find that misrepresentation of pertinent facts is a leading indicator of future fund failure. This strongly suggests that the role of the auditing firm is an important one in the market for investment services, especially hedge funds and other service providers that are lightly regulated.
Full study below (and attached):