• Out of the Dark: Hedge fund reporting biases and commercial databases

    Posted January 20, 2012 By in News With | Comments Off article_image_opt3

    A critique of hedge fund commercial databases by Adam L. Aiken (Quinnipiac University), Christopher P. Clifford (University of Kentucky), and Jesse A. Ellis (University of Alabama)
    Published November 16, 2011

    Are the attractive returns hedge fund surveys present truly indicative of hedge fund’s ability to deliver sustainable alpha? For years investors have relied on commercial databases, despite their recognized deficiencies, to assess the investment merits of hedge fund investing. Without public disclosure on the composition and performance of hedge funds investors are not able to gauge the impact on databases of hedge fund managers’ ability to decide whether and when to include their funds, often with the advantage of a free look back period. Or the ability to remove their funds at their own discretion, often again with a free option of skipping reporting for a short period with the hopes of jumping back in if and when performance rebounds. While studies have attempted to gauge the impact of “self-selection” and the loss of “dead funds” on performance databases, the lack of broad, standardized information has made it difficult to draw definitive conclusions.

    This paper takes a unique approach to assess the known deficiencies in hedge fund performance surveys. In their attempts to broaden distribution many hedge fund managers have registered their funds with the SEC. With registration comes the obligation for public disclosure of fund holding information. Many of these registered fund-of-funds in turn invest across a significant cross section of the hedge fund market. The authors distilled the public disclosures of these funds to develop a universe of 1,445 distinct hedge funds for 2004-2009. More importantly, roughly half of these funds are not included in any of the major commercial databases, thus presenting an opportunity to gauge differences, if any, between those funds where managers choose to present their results in a database and those who elect to remain private.

    The analysis draws conclusions which challenge the prevailing wisdom that hedge fund managers, unlike their mutual fund peers, are able to leverage unique skill, freedom from restrictive policies, attractive incentive structures, and unique trading strategies and vehicles to deliver sustainable levels of alpha. The study uncovers substantial performance premia between those funds reporting to databases and those opting to remain private. The registered fund data also provides insights to the performance of funds listed in surveys versus those removed, with the listed funds outperforming listed funds by, again, substantial margins. The study concludes the impact of self-selection biases, both on the way in and out of commercial databases, are enough to offset the alpha claims of the industry, “We find evidence that most of the average fund’s alpha can be explained by its decision to voluntarily report its performance to a database.”

    Though the industry may challenge the study based on a universe of limited registered funds, the authors’ present compelling evidence of the representativeness of their universe. What is certain is that increased levels of transparency in the hedge fund industry can provide better information for investors to conduct their due diligence and, perhaps, for policy makers to gauge embedded systemic risks. Maybe greater scrutiny of the space can lead to better- informed allocations of capital and greater understanding of risk.

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